AGENCY THEORY

Principal Agent: When one or more individuals hire others and delegate responsibilities to them.
-Right and responsibilities are specified in an employment contract with includes :
Compensation arrangement Information system (moral hazard/adverse selection) (private information though input measurement is ok).

-All individuals are motivated by self interest. Agency problem: When the cooperative behaviour, which maximizes the groups welfare, is not consistent with individuals self interest. This occurs if employment contract is such that, one or more individuals could make themselves better off by deviating from cooperative behaviour and gradually others may find it in their best interest to deviate. The end result: the group suffers loss of efficiency and all individuals are potentially made worse off.

Study Areas:

-Economic Context
-Causes of loss of efficiency created by divergent behaviour -Implications for control processes - Mitigating efficiency loss 3 Branches of Study: PA Model Transaction Cost Economics Model; Rochester Model The three branches differ in their approach w.r.t:

-Modeling of the economic context. - Deviation from optimal employment relationship; - Validation of models

PRINCIPAL AGENT MODEL -Takes the organization as given - Issues is choice of extant employment contract and information system.

Assumptions:
- Individuals are rational - They have unlimited computational ability. - They can anticipate future contingencies (and their probabilities used in provision of contract (ex post verifiable) - The contingencies are jointly observable and can be costlessly used in provision of contract. (ex post verifiable) - Contracts are costlessly and accurably enforced by courts. - Agent has private information to which principal cannot costlessly gain access (Information asymmetry action choice or state information) - Agent is work averse and risk averse

What Prevents Cooperative Solution:

Information asymmetry together with agents work aversion and risk aversion -If all the risk is borne by Principal, the agent gets fixed remuneration, the work averse agent does not work.

-If all the risk is put on the agent (Principal for example gives the production system to the agent for a fixed fee) the risk averse agent does not like it.
The issue how to balance, so that there is a proper trade off between efficient risk sharing and efficient production. Focus; formal analysis of consistency; implications for control monitoring system, budgeting system, variance investigation system, cost allocation system and transfer pricing system.

Criticism against Principal Agent Model:

-Unrealistic assumptions: complete computational requirement, courts can costlessly enforce, etc. are unrealistic. -Oversimplification (of model) it models single owner whereas in many cases there are multiple owners: Restricted view of environment, does not consider capital/labour market etc. which has impact on contracts. Modelling is done at one level; not with multiple hierarchies. -Complexity of solution: The complex models which emerge have no comparability with real life contracts which are seen.

TRANSACTION COST ECONOMICS MODEL

Assumptions: -All individuals act in their own self interest - Individuals do not have unlimited computational ability. (P.A. Model assumes differently) - Individuals have limited capacity (-do-) to acquire and process information. - There are costs in decision making and contracting (PA assumes costlessness) - Courts are imperfect enforcers of contract (PA model assumes differently).

WHAT HAPPENS IN THE TEC MODEL

Since all contingencies are not foreseen (because of bounded rationally) these cannot be entered into contracts. Similarly, since each contracting has cost, intentionally some contingencies are not included. Therefore unlike PA model contracts here are relatively incomplete. In this situation when eventually contingencies arise, each party tries to exploit it to his advantage. Hence, cooperative and self interested behaviour diverge.

Therefore, greater loss of efficiency in TEC model Vs PA model.

What prevents Cooperative Solution:

- Bounded rationally - Costly contracting - Imperfect enforcement of contract (Note that vis--vis PA model, here even in the absence of risk aversion, cooperative solution may not be achieved)

FOCUS
-To organize transaction costs, so that such costs are minimized (Transaction costs: Computational costs, costs of enforcing contracts, opportunity costs). -Emphasize self enforcement, because of diminished role of court enforcement. - Since contracts are incomplete, it gives scope to provision for discretionary compensation (PA does not allow this). -Role of governance procedure for negotiation (in case of incomplete contracts becomes important). * Bargaining power in negotiation becomes important. * Investment (extant) in relation specific assets may improve bargaining power.

Contribution Bargaining Position Investment in relation specific assets Governance Procedure and matters THE ROCHESTER MODEL It is same as TEC Model in the sense that both emphasize -Transaction cost and Opportunistic behaviour But it also takes into account the labour + capital market and thus addresses one of the criticism of other models. What prevents cooperative solution: Due to the presence of transaction cost, it implies incomplete contracts, which together with opportunistic behaviour prevents cooperative solution.

Contribution -Helped early application of agency frame work to management control issues. -Empirical testing of regularity in management behaviour and the form of executive compensation contracts.

Criticism -Concept of equilibrium, and efficiency as well as size and source of transaction cost are not well specified. -Modeling is deemphasized given that contracts are assumed to be optiomal, given transaction cost. As a result, difference in contracts are not exploited.

EMPIRICAL FINDINGS Evidence on Financial Decisions: Empirical findings support the following:

Capital investment decisions Merger and acquisitions decisions Financial accounting procedure,

are associated with compensation plans.

(e.g. long term performance plan corporate capital investment decisions) Evidence on Design of Contracts to Overcome Agency Problem:

Learning to do better ------ Compensation package (+ relationship) Longer decision horizon ---- Can be influenced by compensation package.
Proper contract design may reduce moral hazards.

In reality contracts designed to overcome moral hazards are indistinguishable from contracts written to overcome adverse selection.

There is direct evidence (empirical) that agents act opportunistically but respond to their compensation plans and that principals are aware of this and choose employment contracts which efficiently mitigate this agency problem.

Controllability and Informativeness are two important thrust areas in PA contract design. It is empirically found that initially the agent is guided by the controllability aspect, though gradually his behaviour converges towards informativeness.

Recent work on P-A Paradigm

-Court enforcement and contract incompleteness

-Contract incompleteness and Renegotiation

-Complexity of contracts -Role of reputation among contracting parties. -Multi-period contracts -Use of cardinal and ordinal measures of performance. -Strategic aspects of contract choice -Labour and capital market