Lecture 4 - Agency Theory (copy)

Agency theory

Describes the relationship between a principal and an agent who makes decisions on behalf of the principal.

Positive theory of agency

firm is viewed as a nexus of contracts.

how do contracts affect the behavior of participants and why do we observe certain organizational forms in the real world?

Theory of principal and agent

•how should the agents’ reward structure be designed?

On the job consumption

any type of monetary spending in the company that doesn’t add value to the company.

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Example: Purchase of a company yet

Bonding

monitoring that is initiated by the manager to perform better on the job

Monitoring

monitoring on behalf of the principal to monitor the agents’ behavior

Entrepreneurial firm

a firm without separation of ownership and control, the same person as owner and manager

Team production

when 2 people can do one job more efficiently together than separately

Shirking

as people are thought to be opportunistic, we believe that when 2 people do one job both will slack off because their payout will be constant.

Monitor

a person monitoring if people are shrinking.

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The “….” should be better at monitoring than the agents because if he is not then he is not needed.

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His payout is structured by getting any excess that the group earns on their fixed payout.

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In entrepreneurial firms, the “…” is the manager.

Powerful mechanisms to reduce On-the-job consumption

Stock market/ market for corporate control

Markets for managerial labor

Markets for the company product

Pay package

Decision management

Initiation and Implementation

Initiation

which is the generation of proposals for resource utilization and structuring contracts

Implementation

Which is the execution of the ratified decisions

Decision control

Ratification and monitoring

Ratification

Which is the process culminating in choosing which of the initiatives is to be implemented

Monitoring

Which is the measurement of the performance of decision agents and implementation rewards.

Theory of principal and agent

•The main question here is how the reward structure of the agent should be structured

2 types of contracts

Performance outcome based contracts

Behavior based contract

Performance (outcome)- based contracts

high performance leads to rewards

Behavior based contract

high effort leads to rewards

Other types of contracts

Wage contract

Rent contract

Wage contract

fixed contract

Rent contract

Outcome based contract

Reservation wage

Reward structure: depending on result pay off + fixed component

Pareto-optimal solution

It’s impossible to increase one person’s expected utility without decreasing another one’s

First best solution

If The principal can observe the effort of agent

Second best solution

If the principal can’t observe actions of agent