6 pages 48 hours (A0109)

KEY ISSUES

Key Terms

 Market for Corporate

Control

 Market for Managerial

Labour

 On-the-job consumption

 Bonding and monitoring

 Team production

 Shirking

 Incentives

 Forcing Contract

 Wage Contract

 Rent Contract

 Risk

 Signal

 Observability

 First best solution

 Second best solution

 Internal Labour Markets

Information & Organisational Design LUBS5002

Lecture 5 – Agency Relations Between Owners, Managers and Employees: Incentives and Govrenance

INTRODUCTION

In this session we study the ideas of agency theory which has similarities with our

previous study of game theory. Agency theory looks at any situation which involves two

parties and requires one of the parties (the agent) to act in the best interests of the other party

(the principal). The aim of the principal is to devise a contract or organisational procedures

that motivates the agent to realign their objectives with those of the principal.

As with game theory it is evident that agency theory can be applied to a wide number of

business issues; economic, organisational, marketing, strategy and so on. In this unit we pay

particular attention to the analysis of the separation of ownership and control that occurs in

most modern organisations and what impact it has on the behaviour of management and on

the value of the firm.

In the second part of this unit, we introduce the issues of observability and risk to analyse

the problems in ensuring goal congruence amongst the agency relationship. We also look at

how the principal can get the agent to work according to the principal’s objectives under

different conditions of observability and risk.

Reading

Economic Approaches to Organisations (2013) 5 th

edition, Sytse Douma and Hein Schreuder.

Prentice Hall. Chapters 7 & 15

Further Reading

Alchian, Armen A., and Harold Demsetz. 1972. "Production, Information Costs, and

Economic Organisations", American Economic Review 62, pp. 777-795.

Fama E. F. and M. C. Jensen 1983a, “Separation of Ownership and Control”, Journal of Law

and Economics, vol. 26, pp301-26.

Fama E. F. and M. C. Jensen 1983b, “Agency Problems and Residual Claims”. Journal of

Law and Economics, vol. 26, pp327-50.

Jensen, M. and W. Meckling. 1976. "Theory of the Firm: Managerial Behaviour, Agency

Costs and Ownership Structure." Journal of Financial Economics, 3, pp305-360.

Milgrom P and Roberts J (1992) Economics, Organisations and Management, Englewood

Cliffs, NJ: Prentice Hall.

OBJECTIVES

After completing this unit you should be able to:

1. Understand the impact of the divorce of ownership and control on management behaviour and shareholder value

2. See the role of the firm as a nexus of contracts and the problems this entails. 3. Be able to determine how to get agents to act in your best interests. 4. Relate the importance of information, observability and risk to the design of incentive

contracts.

5. Understand the importance of the firm’s culture to goal congruence.

Theory of Principal and

Agent

Managerial Behaviour

Entrepreneurial Firms

and Team Production

Monitoring and

Bonding

Separation of

Ownership and Control

The Firm as a Nexus of

Contracts

Informational

Asymmetries /

Observability.

Information and

Organisational Design LUBS5002

Lecture 5

Agency Relations between Owners, Managers and

Employees

Objectives

 understand the potential impact of the separation of ownership from control on management behaviour and shareholder value.

 view the firm as a ‘nexus of contracts’ and understand the agency problems that might arise.

 be able to determine how to get agents to act in the best interests of the principal.

 relate the importance of information, observability and risk to the design of incentive contracts.

Introduction

‘Well, then, says I, what’s the use you learning to do right when it’s troublesome to do right and ain’t no trouble to do wrong, and the wages is just the same?’

Huckleberry Finn

Introduction

Two streams of literature within agency theory:

1. Positive theory of agency

How do contracts affect the behaviour of participants?

Why do we observe certain organisational forms in the real world?

2. Theory of Principal and Agent

How should the principal design the agent’s reward structure?

Positive Theory of Agency: The Separation of Ownership and Control

‘The Modern Corporation and Private Property’1932

Adolphe Bearle and Gardner Means

The dispersal of shares across investors has created an effective separation of ownership and control

Do we observe significant differences in the profitability of owner-controlled and manager-controlled firms?

Cadbury Committee (1992) and Greenbury Report (1998)

Constraining Management

Behaviour  Market for Corporate Control

(Henry Manne, 1965)

 Market for Managerial Labour

 Market for the Company’s Products

Theory of the firm:managerial behaviour,

agency costs and ownership structure

Jensen and Meckling (1976)

Analysis based on trade-off between the value of the firm and the present value of on-the-job

consumption

Work has clear predictions about the behaviour of managers under different ownership structures

of the firm

Jensen and Meckling (1976)

Entrepreneurial - principal-agent problems do not exist, thus on-the-job consumption does not act to reduce the value of the firm.

As separation of ownership and control becomes more marked, the potential for on-the-job consumption to increase to the detriment of shareholder value, increases.

Agency problems, clearly create difficulties for prospective shareholders in valuing the company.

Firm Value and Consumption:

Manager Owns All the Shares of His Firm.

Manager Owns Fraction of Firms Shares

Justifying the ‘Classical Firm’

Alchian and Demsetz (1972) provide a ‘property rights’ justification for owner-controlled firms.

They consider a situation with team production, in which output is the joint product of several workers contributions and where an individuals contribution is difficult to define and observe.

Moral hazard problem inherent in team production:

- shirking and free-rider.

Alchain and Demsetz (1972)

Solution to this incentive problem is use of a ‘monitor’.

‘But who monitors the monitor?’

Their solution is for the monitor to be motivated by receiving the residual returns.

In other words, efficiency dictates we end up with the classical owner-controlled firm - an organisation in which the owner hires, fires, and directs workers who are paid a fixed wage.

Ownership and Control in Practice.

“Although seemingly intuitive, the logic that a strong connection exists between the owners of an enterprise and those who control the enterprise has far reaching implications. There may be some doubt forming in your mind at this point. You may be questioning the findings which stem from this look at team productions, pointing out that no one entity could ever simultaneously “own” and “control” a firm such as IBM or ICI. Actually your point is right on the mark and well taken. No single entity could ever accomplish this task. The problem facing large and small organisations is to determine the best way to simulate, or approximate, this necessary connection between ownership and control” (Fitzroy et al 1998).

The Firm as a Nexus of Contracts

Fama and Jensen (1983) see organisations as a nexus of

contracts particularly over residual claims and decision

processes.

1. Initiation

2. Ratification

3. Implementation

4. Monitoring

Argue that separation of security ownership and control can

be an efficient form of organisation

Decision

Management Decision

Control

The Agency Relationship

Agency theory examines the use of financial incentives to motivate workers.

An agency relationship exists when one individual, called the agent, acts on behalf of another, called the principal.

The terms of the agency relationship are spelt out by contract.

At minimum the contract must satisfy two types of conditions

1.The threshold wage

2.The incentive compatibility constraint.

If the agent does not act in the principal’s best interest, the agent is shirking.

The First-Best Efficient Contract

3 factors contribute to an economically efficient contract

 There is no hidden information.

 Observability of actions and outcomes.

 Absence of risk.

Under these conditions, opportunism by the agent is impossible.

Principals know what to expect, can determine if actions/outcomes meet expectations, and can fairly reward agents who act efficiently.

Optimal level of agent’s effort:

Principals View

Problems in Agency Relationships

Moral hazard describes situations in which the agent does not act in the principal’s best interest, and which cannot be prevented by contract.

Moral hazard is closely related to concepts of hidden action and hidden information

Observability - when the results of work are not easily measured or cannot easily be observed then this limits the efficiency of the contract. If this is the case, the principal may measure another outcome as a proxy, so long as it is highly correlated with the desired measure

The two chief obstacles to this theoretical ideal are moral hazard

and imperfect observability.

The “Second-Best” Contract

The agent’s risk aversion - in general the more risk averse the agent, the lower the optimal value of B.

The agent’s effort aversion - in general, the more effort averse the agent, the lower the optimal value of B.

The marginal contribution of effort to profitability - in general the lower lower the MC of effort to profitability the lower the optimal value of B

The noisiness of the performance measure - the noisier the measure the lower the optimal value of B.

W = A +BX where A is fixed component of agent’s compensation

X is measured performance and

B is extent to which compensation is tied to performance.

Trade-off between Incentives

and Risk-Bearing

Issues with Individualised Incentives

 They are strong motivators, dependent only on each individuals marginal product of labour. They elicit self-selection, and they are easily understood. Motivates employees to reveal their private information.

 Can distort employees allocation of their time and effort away from efficient patterns when there are concerns other than the sheer volume of output or sales – e.g. quality (Pendleton and Robinson 2010).

 Pay that depends on output exposes employees to greater risk than would a fixed wage contract, with attendant costs (level of incentives required).

 Agents have limited liability – efficiency wage

 Potential of ratchet effect.

Alternative Solutions to Agency

Problems

Firms frequently rely on internal labour markets to solve agency problems, notably implicit contracts.

Firms use a combination of reward systems to realign

incentives and reduce agency costs.  Wages tend to be backloaded, both to encourage loyalty

and motivate younger workers.  Bonuses increase the degree to which pay is tied to

performance  Promotions serves as another carrot to motivate workers  Tournaments for fewer but higher recompensed

executive positions.

Group Based Incentives  Profit-Sharing

 Employee Share Ownership Schemes – SIP, SAYE etc.

 Theory here is limited, but are several reasons to suppose that incentives provided to groups of employee may sometimes be as effective, or even more effective, than individual incentive contracts.

 Determining individual contributions is impossible – team based work

 Group incentives encourage co-operation

 Group incentives derive their effectiveness from the ability of small groups to monitor and enforce good behaviour among themselves – the potential to self-police their activities by withdrawing help from those workers who shirk.

Group Based Incentives - Issues  Individual employees may resist their employer’s directives if the

employer’s wishes conflict with those of the group. By using group incentives to change the interests of the group as a whole, the employer may make everyone willing to work more effectively.

 Set against this are many of the benefits of individual incentives:

 group incentives no longer reward you according to your individual level of effort,

 free-riders (1/n problem),

 Weak incentives.