Self-Interests & The Agency Problem

RECAP: What Do We Know So Far? Human nature, in general, can be best described by the REMM model: We are resourceful, evaluative, and seek to enjoy the highest level of value possible (I.e., we are utilitiy maximizers) (Jensen and Meckling, 1994) Unlike what is postulated in other models of human behavior, we are motivated by more than money, we do make substitutions in goods, and we are not perfect agents

RECAP: Why is the understanding of human nature useful information to an organization? A firm is a nexus of contracts. Thus, such an understanding allows for two things: 1) Better specification of contractual terms that support and encourage individual behaviors that contribute to the organization’s objectives and goals. 2) Increased effectiveness of control mechanisms that enforce the contractual terms.

RECAP: How does accounting fit in? In contracting: Accounting ______ the terms of the contract. _______________ In organizational control: Accounting provides a _________ framework. Target vs. actual

More on Contracting and Individual Behavior: The Agency Problem Agency relationship: A contract under which one or more persons (the principal(s)) engage another person (the agent) to _________________________________. Agency Problems: conflicts of interests between the ________ and those of the _______. The problem of inducing an _______ to behave as if s/he were maximizing the ________(s)’ welfare.

Examples of the Agency Problem In the public sector, representatives are supposed to look out after the interests of the districts that elected them. But they often take bribes and raise their perks and pay at the public's expense. In the private sector, CEO's are supposed to look out after the profitability of the company, and attend to the satisfaction and welfare of its customers, stockholders and workers. But CEOs often help themselves to skyrocketing salaries and golden parachutes, even as they downsize their employees and defraud stockholders.

What causes agency problems? The agent acts upon self-interests that often diverge from (conflict with) that which maximizes the principal’s welfare. Moral hazard The tendency, after closing a contract that transfers risk to a second party, to behave in a more ________ manner than one would otherwise, had s/he not entered the contract and retained all the risk. -Adverse Selection An ______ or _______ exchange on the market caused by differences in information (information asymmetry) between the two parties.

What eases agency problems? ____________________ between the principal and agent that minimizes differences between the agent’s self-interests and the interests of the principal. Examples include: holding elections tying incentive pay to the welfare of the group or organization screening agents for good character and personal backgrounds, setting up a system of regular scrutiny and punishment for direlect behavior. Ultimately, no organization solves its agency problem 100 percent, because the _______ of ensuring such agency eventually outweigh the _______.

What are the costs involved in easing the agency problem (i. e What are the costs involved in easing the agency problem (i.e., agency costs)? Agency costs are the sum of: ________________ costs of observing and controlling behavior (e.g., audits, budget restrictions, compensation policies, formal control systems, operating rules) Costs associated with ensuring against loss or damages to the principal caused by failure of an agent to act in the best interests of the principal (e.g., contractual guarantee to have financial accounts audited, explicit bonding of agent (via bond insurance), contractual limitations on manager’s decision-making power) ________________ (loss assoc. w/ not solving the agency problem 100%) The dollar equivalent of the reduction in welfare experienced by the principal due to the divergence between the agent’s actions/decisions and those actions/decisions that would maximize the principal’s welfare

Conservation of Value Principle The goal of both principal and agent to __________ agency costs.

Second Source of Agency Costs Costs incurred as a result of self-control problems (_____________ behavior) _____________ behavior: dysfunctional or counterproductive behavior that systematically harms the individual The Pain Avoidance Model (PAM) best describes this behavior as the “flight or fight” response Responses that lead to more ______ when trying to avoid pain; ________________ that leads to little to no learning, lack of change

Again, how does accounting fit in? Recall in contracting: Accounting defines the terms of the contract. Performance measures Targets (e.g., budget restrictions) Links between performance and pay (e.g., compensation policies such as incentive contracts) Recall in organizational control: Accounting provides a monitoring framework. Target vs. actual Specifically, We do all of the measuring of the terms of the contract. We monitor the agent’s activities (I.e., primary component of monitoring costs)

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