Where does agency cost / principal-agent collide?

The loss in firm value that arises because a manager who does not own the whole firm pursues their own ends rather than the owners' wealth. Jensen and Meckling's 1976 Theory of the firm defined agency costs as the sum of the principal's monitoring expenditures, the agent's bonding expenditures, and the residual loss that remains when the agent's decisions still diverge from those that would maximise the principal's welfare. They traced two relationships, between an owner-manager and outside equity and between shareholders and debtholders, and argued that the capital structure of the firm is itself a response to these costs. The referent is a measurable loss in value under delegation, not a person's capacity to act.[1]

Unit

The value lost when a self-interested manager is delegated to under information asymmetry

Recovery means

Not applicable

Measured by

Estimated from monitoring, bonding, and residual-loss proxies, and from the value effects of ownership and leverage

The formal problem of designing a contract that induces an agent to act in the principal's interest when the agent's effort or information cannot be fully observed. Ross's 1973 The economic theory of agency posed the principal's problem as choosing an incentive scheme under uncertainty, and the literature that followed split the difficulty into hidden action, where the agent's effort is unobserved and moral hazard results, and hidden information, where the agent knows something the principal does not and adverse selection results. The optimal contract trades off insuring the agent against risk with sharpening their incentive to perform. Here the construct is a model of contracting, timed and solved rather than measured in a firm.[2]

Unit

An incentive contract between an informed agent and an uninformed principal

Recovery means

Not applicable

Measured by

Characterised analytically by the incentive-compatibility and participation constraints of the optimal contract

The account of the firm as a nexus of principal-agent contracts, used in corporate governance and strategy to explain boards, incentives, and ownership as devices that align managers with shareholders. Eisenhardt's 1989 Agency theory: an assessment and review separated a positivist strand, concerned with the governance mechanisms that curb managerial self-interest in large corporations, from a principal-agent strand, concerned with the general logic of optimal contracts, and argued the two were complementary. The theory supplies the standard rationale for pay for performance, independent directors, and the market for corporate control. What differs from the finance version is the object of study: governance structures rather than the value they cost.[3]

Unit

A governance arrangement that aligns a delegated manager with owners

Recovery means

Not applicable

Measured by

Assessed by the effect of boards, incentive pay, and ownership on managerial behaviour and firm outcomes

The legal relationship in which one party, the agent, is empowered to act on behalf of another, the principal, and thereby owes fiduciary duties of loyalty and care. The Restatement (Third) of Agency defines agency as the fiduciary relationship that arises when a principal manifests assent to have an agent act on the principal's behalf and subject to the principal's control, and the agent so consents. The duty of loyalty forbids the agent from self-dealing or taking the principal's opportunities, and the duty of care sets a standard of competence; breach gives the principal a remedy. The referent is a normative relationship enforced by courts, not a cost to be minimised or a contract to be solved.[5][4]

Unit

A fiduciary relationship of delegated authority governed by duties of loyalty and care

Recovery means

Not applicable

Measured by

Adjudicated against the duties of loyalty and care rather than quantified