EO Lecture 5 March 2018 (Ratnes Rasiah)

Slide 1.
ECONOMICS FOR ORGANISATIONS

ECN61404
L5: Agency Theory (1) – Ownership, Control,
Production and Contracts.
Douma, S. & Schreuder, H. (2017),

Chapter 8. Agency theory
Douma and Schreuder, Economic Approaches to Organisations PowerPoints on the Web, 5th edition, © Pearson Education Limited 2013
Slide 1.2
Learning Outcomes
At the end of this lesson, you will be able to:
 Describe agency theory.

 List the two types of agency theory.
 Explain the positive theory of agency.
 Understand the concept of separation of ownership and
control.
 Explain how ownership structure of a firm affects managerial
behavior.
 Differentiate between entrepreneurial firms and cooperative
firms.
 Apply the agency theory in a real scenario.
Slide 1.3
Introduction
 Agency theory, in its simplest form, discusses the relations

between two people
o a principal and an agent who makes decisions on behalf of
the principal.
o For instance, the owner of a firm (principal) and the manager
of a firm (agent), who makes decisions affecting the owner’s
wealth.
 Within the agency theory, two streams of literature can be

distinguished:
o The positive theory of agency, and
o The theory of principal and agent
Slide 1.4
Positive Theory of Agency
In this theory, the 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?
– In general, it is assumed in the theory that existing

organizational forms are efficient, if they were not, they
would not continue to exist.
– Basically, this theory sets out to explain why

organizational forms are as they are, (not expressed in
mathematical form)
Slide 1.5
Theory of Principal and Agent
 The central question is how should the principal design the

agent’s reward structure?
 The question is dealt with in formal mathematical models.
 More about this theory in the next lecture…
Both types have their antecedents in the literature on the

separation of ownership and control.
Slide 1.6
AGENCY THEORY
Agency relationship – a Discuss the relations
contract under which one between people – a
SEPARATION OF
or more persons (principal) principal and an agent
OWNERSHIP &
engages another person CONTROL who makes decisions
(agent) to perform some on behalf of the
service on their behalf Officers are in search of power, principal
which involves delegating prestige and money for
some decision making themselves, shareholders for
authority to the agent profits: owner-controlled corp >
profit than manager-controlled
corp
POSITIVE THEORY OF AGENCY THEORY OF PRINCIPAL AND

Berle & Means, 1932; Jensen & AGENT Demski & Feltham, 1978; Harris &
Meckling, 1976; Fama & Jensen, 1983 Raviv, 1979; Ouchi, 1979; Eisenhardt, 1985;
Lamber, 1983
 How contracts affect the behavior of  How should the principal design the agent’s
participants reward structure/contracts – forcing contract,
 Why certain organisational forms are as wage contract, rent contract
they are – entrepreneurial firms and team  Risk is introduced and symmetrical
production information assumption is relaxed -
 Firms as a nexus of contracts – to explain assuming principal can observe or cannot
the existence of entrepreneurial firms and observe the agent’s behavior
public corporations; the 4-steps decision  Identifying which contract is more efficient
process (IRIM) under varying levels of uncertainty
Slide 1.7
Separation of ownership
and control
 Adam Smith recognized the problem resulting from the
separation of ownership:
 ‘Negligence and profusion…must always prevail, more or
less, in such a company’ , The Wealth of Nations.
 Berle and Means describe the separation of ownership and
control…The large corporation, they say, is owned by so many
shareholders that no single shareholder owns a significant
fraction of the outstanding stock.
 Therefore, no single shareholder has the power really to
control the actions of the officers of the corporation.
Slide 1.8
and control
 The officers themselves also owns a very small part of the stock of
their corporations. Hence, the situation may be characterized as
follows:
 The bulk of the dividends goes to the outside shareholders;
 All the major decisions are made by the corporate officers;
 The outside shareholders are unable to control the corporate
officers.
 In that situation, Berle & Means say, the interests of the officers
and shareholders diverge widely. The officers are in search of
power, prestige and money for themselves, while the shareholders
are interested only in profits.
 Senior managers are in a position to enrich themselves at the

expense of the shareholders and sometimes engage in corporate
plundering.
Slide 1.9
and control
 Corporations where officers’ portion are significant is called
owner-controlled corporations.
 The corporations with widely dispersed shareholdings are

called manager-controlled corporations.
 Thus there should be a significant difference in profitability;

owner-controlled companies should be more profitable than
manager-controlled companies.
 There are however powerful mechanisms that prevent

managers from engaging in excessive on-the-job
consumption.
Slide 1.10
Mechanisms to prevent on-the-

job consumption (pp140-141)
 Stock market
 Market for managerial labour
 Markets for the company’s products
 Managerial pay package
Slide 1.11
Managerial Behaviour and

Ownership Structure
 How does the ownership structure of the firm affect the

behavior of managers in that firm?
 Jensen & Meckling (1976)
 Consider a manager who owns all the shares of the company
she manages. That owner-manager has two conflicting
objectives. She is interested in maximising both the value of
the firm and on-the-job consumption.
 The latter may take various forms, such as buying a company
jet or furnishing the office in a luxurious way.
Slide 1.12

Ownership Structure
 Suppose the manager is interested only in maximising the value of a
company. Such a manager would first calculate the following:
o The present value of the managerial time saved by buying a company
jet (a).
o The present value of buying tickets for regular airlines (b)
o The present value of the cash outflows from buying and operating a
company jet (c)
 A manager interested in only maximising the value of a company would buy
the jet only if
c-a < b
 Now define d as d = c-a-b and suppose that d is greater than zero. A
manager interested in not only maximising the value of the firm but also in
prestige and personal comfort might still buy a company jet. If so, d is the
amount spent as on-the-job consumption.
Slide 1.13

Ownership Structure
• From the example it is clear that, if managers engage

on on-the-job consumption, they are not maximising
the value of the firm.
• The more is spent as on-the-job consumption, the
lower the value of their firms. If a manager spent
$1million as on-the-job consumption (d), she would
lower the value of the firm by $1million.
• See Figure 7.1
Slide 1.14
Value of the firm (V) and present value of on-the-job consumption

Figure 7.1
(C).The manager owns all the shares in the firm
Slide 1.15
Figure 7.1
 In the figure, the present value of on-the-job consumption, C

is plotted against the value of the firm, V.
 It is now clear that the sum of two variables – value of the
firm and present value of on-the-job consumption – is
constant.
 If the manager decides to consume C5, the value of the firm
will be V5. The line V0C0 represents all possible combinations
of V and C. That line gives the set of combinations of V and C
the manager can choose from and its called the budget
constraint.
Slide 1.16
Figure 7.1
 The values of C and V chosen by the manager depend on her

utility function. In the figure, all points on curve U3, U2 and U1
represent points of equal utility to the manager.
 Points on curve U1 however, represent a higher utility than points
on U3. Points on U2 is impossible to achieve.
 The manager maximizes her utility by choosing point P1, where her
consumption is C1 and the value of the firm is V1. At that point, the
marginal utility of an additional dollar of on-the-job consumption is
equal to the marginal utility of an additional dollar of wealth.
 As we are dealing with a manager who owns all the shares in the
firm, we need only the information in Figure 7.1 to determine her
trade-off between the value of her firm and her on-the-job
consumption.
Slide 1.17

Ownership Structure
 Now suppose the manager sells a fraction (1-α) of her shares

to outsiders. The manager then owns a fraction α of the
shares herself.
 See Figure 7.2
 Say, α = 0.7, which would mean that the manager sells 30% of
the shares to outsiders and retains 70% herself. If she decides
to spend an additional $1 on-the-job consumption, the value
of the firm will be reduced by $1. Now, however, the personal
wealth of the manager will be reduced by only 70 cents. And
the wealth of the outside shareholders by 30 cents.
Slide 1.18

Ownership Structure
 How much more the manager will spend on on-the-job
consumption depends on the set of possible combinations of
personal wealth and on-the-job consumption she can choose from.
 That set depends on the price she can achieve for the shares she
sells to the outsiders, which depends on whether or not the
outsiders know beforehand that the manager will spend more on
on-the-job consumption after she has sold the shares.
 Figure 7.2: outside shareholders were naïve, do not know that the
manager will spend more on on-the-job consumption.
 Figure 7.3: outside shareholders were not so naïve, expects the
manager to increase her on-the-job consumption.
Slide 1.19
Figure 7.2 Value of the firm (V) and present value of on-the-job consumption (C).
The manager owns a fraction α of the shares. The outsiders expect no increase in
on-the-job consumption after the manager has sold a fraction (1 − α) of the shares
Slide 1.20
Figure 7.2 and 7.3

 Fig 7.2: If the outsiders do not know the manager will spend more on on-the-
job consumption), such naïve outsiders will be willing to pay 30% of V1, for
30% of the shares. At point P1, the manager consumes C1 and her personal
wealth is V1 (she will have 30% of V1 in cash and the other 70% of V1 in
shares). The budget constraint facing the manager has a slope of -0.7, L, since
the manager can trade $1 of consumption for 70 cents of personal wealth.
 At point P2 there is an indifference curve U2, tangential to the budget

constraint, L. at that point the manager consumes C2. The value of the firm is
reduced to V2. thus the outside shareholders who paid 30% of V1 for their
shares now find that their shares have a value of 30% of V2 only.
 Fig 7.3: Suppose now the outsiders were not so naïve, they expected the
manager to increase her consumption as soon as she sold the shares.
Assume that they know the shape of the managers’ indifference curves.
They would try to find P3.
Slide 1.21
Figure 7.3 Value of the firm (V) and present value of on-the-job consumption (C).
The manager owns a fraction α of the shares. The outsiders know the exact shape
of the indifference curves of the manager and adjust the price they are willing to
pay accordingly
Slide 1.22
Figure 7.3
 Point P3, such that P3 lies on V0C0 and the indifference curve
passing through P3 has, a slope of – α (that is the indifference
tangential at P3 to a line through P3 with slope - α)
 The outsiders will soon find out that there is one, and only one
such point, P3. Thus they will know at point P3, the MU of the
managers of spending an additional $1 on on-the-job
consumption is equal to the MU of 70 cents of personal
wealth.
 Therefore. they are willing to pay only 30% of V3 shares not
30% of V1.
 The value of the firm will be V3 and the outsiders will neither
gain nor lose from buying the shares.
Slide 1.23
Figure 7.3
 The personal wealth of the manager is now V3. Of this amount, she has a
fraction (1- α) in cash and a fraction α in shares. Her wealth has reduced by
V1-V3 and the present value of her on-the-job consumption has increased
by C3-C1.
 The result is a decrease in her level of utility; she is now on indifference
curve U3, having started on indifference curve U1.
 Thus it is clear that no manager would ever sell a fraction of the shares of
her company unless there were something else, not included in the
analysis. Three possibilities could be:
– The manager prefers to have a portion of her wealth in cash instead of
shares because she can then use the cash for other things;
– The manager wants to diversify company-specific risk;
– The manager sees an opportunity for investment that she cannot
finance out of her own personal wealth.
Slide 1.24
Monitoring
 Situations above discussed the case of a manager-owner who wants to
sell part of her shares to an outside investor. After she has done so, she
will engage in more on-the-job consumption. Why can’t she simply
promise not to do so?
 In the above analysis we assume that the outside shareholders cannot
prevent the manager from consuming more on the job after she has
sold part of her shares.
 Suppose now that outsiders can monitor the behaviour of the managers
to a certain extent. In fact, it is usually possible for outsiders to observe
the behavior, for instance by having the books audited by an external
auditor.
 Monitoring (though not without cost), could reduce the manager’s on-
the-job consumption. The more spend on monitoring, the better they
can observe the manager’s behavior, thus can reduce her on-the-job
consumption.
Slide 1.25
Bonding
 Noting that the manager bears full cost of her increase in on-the-
job consumption, if manager can convince the outsiders before
selling the shares that she will consume less than C3, she will be
able to sell the shares for an amount greater than 30% of V3. If she
consumes less, the value of the firm increases and it is the manager
who captures that increase, not the outsiders.
 It is in the interests of the manager to bind herself, called bonding.
 Bonding and monitoring are almost the same thing. Bonding
means that the manager takes the initiative to bind herself and be
monitored; monitoring means that the outsiders take the initiative.
 Monitoring costs and bonding costs are borne by the manager.
Slide 1.26
Monitoring & Bonding
 Like monitoring, bonding is not without cost. It involves the same

kinds of activity as monitoring: the manager takes the initiative to
have the books audited or install a board of directors.
 Monitoring costs and bonding costs are borne by the manager. By
consuming less than C3, she increases her level of utility. By
spending money on monitoring and bonding, she decreases the
value of the firm. For this reason her budget constraint is no longer
shown by the line V0C0. rather, her budget constraint now is curve
S. See Figure 7.4.
 The manager spends an amount MB (equal to the distance P5P4) on
monitoring and bonding costs. Her level of utility is U4, higher than
U3 but still lower than U1.
Slide 1.27
Figure 7.4 Value of the firm (V) and present value of on-the-job consumption (C)
with monitoring and bonding costs
Slide 1.28
Entrepreneurial Firms and

Team Production
 Why do entrepreneurial firms exist?
 By an entrepreneurial firm we mean one that is owned and managed by
the same person. That person (the entrepreneur) coordinates and
monitors the work of several others (the employees) and receives the
residual funds after fixed contractual payments (such as wages and interest
payments) have been paid. Here, direct supervision is the most important
coordinating mechanisms.
 An alternative organizational form is workers’ cooperative in which the
workers cooperate as peers. Here, mutual adjustment would be the prime
coordinating mechanism.
 In manufacturing industries, few workers’ cooperatives exist. Alchian &
Demsetz (1972) explain this by using the concept of team production.
 Team production is a situation in which two or more people can produce
more when they are working together than when they are working
separately.
Slide 1.29
Team Production
 Self-employed people receive the fruits of their efforts alone; more
effort, produce more and earn more money.
 Now suppose that n people form a team and share the earnings from
their production activities. Then each person knows that is he puts in
an extra unit of effort, he will receive only 1/nth part of the additional
earnings generated by his additional effort. For that reason, each
person will be strongly tempted to put in much lower level of effort.
This phenomenon is called shirking.
 With every team member shirking, the total output of the team will
be much lower than if there were no shirking. Every member of the
team is willing to put in more effort, provided that everybody else
also puts in more effort.
 The members of a team can discuss this issue. If easily detected, the
team member who shirks will be expelled. More often, this is not
easily detected – information problem.
Slide 1.30

Team Production
 Suppose it is difficult for other members to detect shirking but
not very difficult for someone whose only task is to detect
shirking. Let us call that person a monitor.
 A team with a monitor would produce more than a team
without a monitor. How should the monitor be rewarded for
his effort?
 If he was rewarded on an equal basis, then he has an incentive
to shirk. Thus, for the monitor to be effective, he must have
the power to revise the terms on the contracts of individual
team members, without having to negotiate. The monitor
must have the right to terminate contract, attract new
members and adjust pay rates of every member and must be
able to sell his rights as monitor.
Slide 1.31

Team Production
 Thus we have the entrepreneurial firm. The monitor is the

owner of the firm, who receives the residual funds, has the
right to sell the firm, has the right to hire and fire team
members and adjust they pay on an individual basis. The
monitor is the entrepreneur and the other team members are
his employees.
 The classical entrepreneurial emerges in this theory as the
solution to their problem of shirking within teams. The theory
rests on two vital assumptions:
– There is team production
– Monitoring by someone specializing in that function can reduce shirking
Slide 1.32
The Firm as a Nexus (Bunch) of

Contracts
 In previous sections we have discussed that ownership of the

firm is a concept of vital importance – it restricts on-the-job
consumption and shirking by managers.
 How then, can we explain the existence of large corporations,
shares in which are publicly traded and the managers of which
do not own (a significant portion of) the shares?
 A shareholder in a large corporation owns just a number of
shares. Shareholders are just one party in a group of many
parties bound together in a nexus/bunch of contract.
Slide 1.33
The firm as a nexus of

contracts
 Fama & Jensen (1983) use this perspective to explain the
existence of both entrepreneurial firms and public
corporations. They see the organization as a nexus of
contracts, written and unwritten, between owners of factors
of production and customers.
 The most important contracts specify the nature of residual
claims and the allocation of steps in the decision process of
agents.
 Most agents receive a fixed promised payment or an
incentive payment based on a specific measure of
performance.
Slide 1.34
The Firm as a Nexus (Bunch)

of Contracts
 The decision process has four steps:
– Initiation: generation of proposals for resource utilization
and structuring of contracts
– Ratification: process culminating in choosing which of the
initiatives is to be implemented
– Implementation: execution of the ratified decisions
– Monitoring: measurement of the performance of decision
agents and implementation of rewards.
 Initiation and implementation are usually allocated to the

same agents. These two functions are combined within the
term decision management. Likewise, decision control
includes ratification and monitoring.
Slide 1.35
Example
 Suppose that a small entrepreneurial firm (S) is acquired by a

large firm (L). The managers of company S are now no longer
the residual claimants of the company.
 It is likely, however, that they still possess specific knowledge
relevant to making decisions for company S. It is now efficient
to delegate decision management to the managers of
company S. Decision control however is exercised by the
managers and corporate staff of company L.
 In small, non-complex organizations, it is efficient to allocate
both decision management and decision control to those
agents who have specific information.
Slide 1.36
NEXT, AGENCY THEORY PART II
END OF AGENCY THEORY PART I
Slide 1.37

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Slide 1.

ECONOMICS FOR ORGANISATIONS

Douma, S. & Schreuder, H. (2017),

At the end of this lesson, you will be able to:

 Describe agency theory.

 Agency theory, in its simplest form, discusses the relations

 Within the agency theory, two streams of literature can be

Positive Theory of Agency

In this theory, the firm is viewed as a nexus of contracts.

– In general, it is assumed in the theory that existing

– Basically, this theory sets out to explain why

Theory of Principal and Agent

 The central question is how should the principal design the

Both types have their antecedents in the literature on the

POSITIVE THEORY OF AGENCY THEORY OF PRINCIPAL AND

 Senior managers are in a position to enrich themselves at the

 The corporations with widely dispersed shareholdings are

 Thus there should be a significant difference in profitability;

 There are however powerful mechanisms that prevent

Mechanisms to prevent on-the-

Managerial Behaviour and

 How does the ownership structure of the firm affect the

Managerial Behaviour and

Managerial Behaviour and

• From the example it is clear that, if managers engage

Value of the firm (V) and present value of on-the-job consumption

 In the figure, the present value of on-the-job consumption, C

 The values of C and V chosen by the manager depend on her

Managerial Behaviour and

 Now suppose the manager sells a fraction (1-α) of her shares

Managerial Behaviour and

Figure 7.2 and 7.3

 At point P2 there is an indifference curve U2, tangential to the budget

Monitoring & Bonding

 Like monitoring, bonding is not without cost. It involves the same

Entrepreneurial Firms and

Entrepreneurial Firms and

Entrepreneurial Firms and

 Thus we have the entrepreneurial firm. The monitor is the

The Firm as a Nexus (Bunch) of

 In previous sections we have discussed that ownership of the

The firm as a nexus of

The Firm as a Nexus (Bunch)

 Initiation and implementation are usually allocated to the

 Suppose that a small entrepreneurial firm (S) is acquired by a

NEXT, AGENCY THEORY PART II

END OF AGENCY THEORY PART I

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