Week 1 The Agency Problem

The Agency Problem

The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interest. For example, you might hire someone (an agent) to sell a car that you own while you are away at school. In all such relationships, there is a possibility of conflict of interest between the principal and the agent. Such a conflict is called an agency problem.

For example, imagine that a corporation is considering a new investment. The new investment is expected to favorably impact the stock price, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the share value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity.

Here is another example. Employees are part of the firm and, should, therefore, be working toward the common goal of maximizing the wealth of the firm’s owners. But in this respect there is an agency problem. Labor is a cost of doing business which, from the owners’ point of view, should be minimized. From the employees’ point of view, however, the cost of labor (which consists of their wages and salaries) should be maximized. Thus, unless the employees themselves own stock in the company, and are thus owners themselves (a practice common in many companies), there is an inherent conflict of interest between owners and employees.

Dealing with the Agency Problem
Whether managers will, in fact, act in the best interests of stockholders depends on two factors:

• How closely management goals are aligned with stockholder goals (i.e. managerial compensation)
• How easily management can be replaced if they do not pursue stockholder goals (i.e. control of the firm)