Overview of Agency Theory Perspective, Part I

Origins of the agency theory perspective
The separation of ownership and control of wealth creates an agency relationship where one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf. An agency relationship is therefore said to exist when one party delegates decision-making responsibility to a second party for compensation. This relationship is the focus of agency theory and is described using the metaphor of a contract.

The fundamental feature of the contract between principal and agent is the delegation of some decision-making authority to the agent (Jensen and Meckling, 1976). The agent is morally responsible to maximize shareholder utility.

Agency problem
There are several aspects to the agency problem: (1) the interests of the principals and agents diverge or conflict and agents have the opportunity to rationally maximize their own benefits at the expense of principals; (2) it is difficult or expensive for principals to know in advance which agents will self-aggrandize or to verify what agents are actually doing. The problem here is how to check that the agents are acting in an appropriate manner; and (3) the principal and agent may have different attitudes to risk sharing leading to preferences for different actions.
The objective of agency theory then is to reduce the agency costs incurred by principals by keeping the agent’s self-serving behavior in check.

Evidence of the Agency Problem
Conflicts between principal and agent in a firm can affect the investment, operating or financial policies of the firm. Agency problems can be of: (i) effort, where there is less incentive for managers to exert full effort in increasing shareholder value as their ownership of the firm falls (Jensen and Meckling, 1976).2 This shirking, of not putting in agreed upon effort, is also known as a problem of Moral Hazard; (ii) time horizon, where managers prefer investment or operating strategies that have lower costs and produce results more quickly than potentially more profitable long-term projects that have higher initial costs, as they are limited in their future employment whereas firm value is determined by a potentially infinite series of future cash flows; (iii) risk, where managers are generally dependent on the firm for which they work for a large part of their wealth and stand to lose much if their firm becomes financially distressed but benefit relatively little if the firm is successful. As a result, they tend to prefer less risk than shareholders, who through portfolios eliminate firm-specific risk, and tend to view diversification as reducing their exposure to industry- or market-specific risk, even though diversification is associated with a decrease in firm value (Amihud and Lev, 1981).

Sumber:
Jenkins, M., Ambrosini, V., & Collier, N. (2016). Advanced Strategic Management. New York: Palgrave.