CHAPTER 7 Agency Theory
FIN800 Ethics in Finance
CHAPTER 7 Agency Theory
Agency theory: application of game theory to the analysis of a particular social interaction, namely “situations in which one individual (the agent) acts on behalf of another (the principal) and is supposed to advance principal’s goals” o Theory of the firm is a natural extension of economic theory from an analysis of markets to an analysis of internal structure of corporations, in order to bridge the gap between utility-maximization hypothesis and profitmaximization assumption
CONFLICT WITH BUSINESS ETHICS Principal-agent theory is about how individuals manage situations involving “goal incongruity” between two or more persons To clarify the issues of agency theory o Important to get clear on sort of theoretical commitments that are essential to agency theory, in order to distinguish between agency theory itself and certain incorrect interpretations that have become widely promulgated o Important to be more specific about different ways agency theory can be used to analyze relations within the firm, in order to determine whether it is the use or the abuse of agency theory that has become a source of mischief o Important to be more specific about circumstances in which moral obligations can arise out of agency relations AGENCY THEORY AND SELF-INTEREST Assume that conflicts of interest that give rise to agency-risks may result from a variety of motivations, on the part of agents and principals Even if theoretical framework does not force them to do so, agency theorists make unflattering empirical assumptions about individual preferences, by stipulating in their models that, for example, work effort has negative utility, money rewards have positive utility, and individuals have no other relevant motivations Two outstanding problems: 1. The first of two outstanding problems stems directly from the tendency among game theorists to black-box all questions of motivation Theoretical strategy does allow them to sidestep disputes over altruism and egoism, it also leaves them without a developed theory of preference formation, and thus without an ability to model the way that preference changes arise out of social interactions There is nothing intrinsic to agency theory that prevents people from taking interest in the way that internal incentives such as preference change can be used to overcome agency problems; it is just that game theorists have no idea how to model such processes, and so chose to ignore them 2. The second outstanding problem involves commitment on the part of the agency theorist to the view that individuals will behave opportunistically whenever given the chance to do so Two components of opportunism n the standard sense of the term o Taking advantage of circumstances as they arise o Acting without regard for principle Opportunistic behaviour: direct consequence of agents acting in accordance with the general game theoretic principle known as sequential rationality Consequentialism postulate: value of an action is a function of its anticipated consequences, and nothing else (commitment to reoptimization follows almost immediately from this consequentialism) o Possibility that rational agent might incorporate deontic constraints – principles associated directly with actions, independent of their consequences – into his deliberation AGENCY THEORY AND SHAREHOLDER PRIMACY Pure agency relationship: relationship between stockholders and the managers of a corporation o Positive claim about the structure of the firm, not a normative claim about how the firm should be organized o Creates ambiguity concerning who is the agent and who is the principal Incentive theory: principle is the individual whose welfare is to be served and this welfare is affected by an agent who makes decisions on behalf of the principal o Principle is the one whose welfare ought to be served; agent is the one who is under an obligation to serve the principal faithfully
FIN800 Ethics in Finance
Normative stakeholder theory would regard to say that manager is suppose to advance interests of shareholders, to the exclusion of other constituency groups; but managers have no explicit contract with shareholders, nor do they stand in fiduciary relationship with them
AGENCY THEORY AND MISPLACED LOYALTY Another line of objection to agency theory is centered upon the claim that agency relationships, even fiduciary relationships, cannot serve as genuine source of moral obligation; rather, they serve only to transmit moral obligations from one person to another Either agent’s where agency relationship has nothing to do with it and action is ethical where the source must be traced back to some obligation imposed upon the principal; or unethical and agency relationship serves only to obscure that fact, by suggesting that it was done out of loyalty or obligation to the principal Nemo dat principle: nobody gives what he doesn’t have o Agency relationships is unable to create moral permissions where previously none existed o Acting for another does not give one ethical license and that all persons are ethically responsible for their actions, whether performed under command or performed on behalf of another Professionals role can serve as genuine source of moral obligation in that they can transform actions that are merely permissible for the principal into ones that are obligatory for the agent WHAT’S THE PROBLEM? Three potential problems with agency theory from the perspective of business ethicist: 1. Treats all motivation as self-interested 2. Presupposes shareholder primacy 3. Encourages violation of the nemo dat principle Standard defence of agency theorist will be to say that this is all just positive theory; no one is recommending universal opportunism Flawed conception of human rationality is agency theory generates predictions that are at variance with what one can actually observe in the behaviour of individuals and structure of organizations Improper Understanding of Incentives When agency problems do not show up where agency theory predicts that they should, rather than concluding there must be some relevant sort of internal constraint at work, these theorists assume that external incentives must be there, but that they simply have not been discovered Efficiency wage phenomenon: notion that a “fair day’s work is a fair day’s pay pays” a powerful role in determining employee effort level o Efficiency effects of wage increase can be explained entirely through reference of traditional monetary incentives, and without appeal to any obscure internal motivational factors, such as sense of fairness or commitment to reciprocity Framing effect: when translated into practical managerial decision making, might result in mistaken solutions to problems or even incorrect assessments of the problem to be solved Other potential source of mischief is caused by the assumption that, whenever a particular sort of agency cost fails to arise, there must always be an explanation in terms of external incentives Crowding Out of Moral Incentives Crowding out of moral incentives: pecuniary incentives can have the effect of undermining moral incentives o If reward being offered fail to outweigh the free-rider benefits, then the incentive scheme may easily have the effect of undermining cooperation, thereby creating real collective action problems Internal and external incentives are not necessarily complementary or cumulative, even when in theory they are correctly aligned to promote the same outcome Cryptonormativism Normative theory of practical rationality: one that categorizes certain forms of action as rational and certain other forms as irrational The fact that moral rules get categorized with models of irrational, and opportunism as rational, might easily lead more impressionable minds to the conclusion that they should learn to ignore moral constraints Two pernicious consequences 1. In acting more rationally, individuals may begin to plan their own behaviour in accordance with the dictates of instrumental model, and thus begin to act more opportunistically
FIN800 Ethics in Finance 2.
Even if they do not change their own deliberative processes, they may begin to expect higher levels of opportunistic behaviour from others, and therefore feel justified in engaging in pre-emptive defection in order to protect themselves from anticipated defection of others
CHAPTER 7 Agency Theory
Agency theory: application of game theory to the analysis of a particular social interaction, namely “situations in which one individual (the agent) acts on behalf of another (the principal) and is supposed to advance principal’s goals” o Theory of the firm is a natural extension of economic theory from an analysis of markets to an analysis of internal structure of corporations, in order to bridge the gap between utility-maximization hypothesis and profitmaximization assumption
CONFLICT WITH BUSINESS ETHICS Principal-agent theory is about how individuals manage situations involving “goal incongruity” between two or more persons To clarify the issues of agency theory o Important to get clear on sort of theoretical commitments that are essential to agency theory, in order to distinguish between agency theory itself and certain incorrect interpretations that have become widely promulgated o Important to be more specific about different ways agency theory can be used to analyze relations within the firm, in order to determine whether it is the use or the abuse of agency theory that has become a source of mischief o Important to be more specific about circumstances in which moral obligations can arise out of agency relations AGENCY THEORY AND SELF-INTEREST Assume that conflicts of interest that give rise to agency-risks may result from a variety of motivations, on the part of agents and principals Even if theoretical framework does not force them to do so, agency theorists make unflattering empirical assumptions about individual preferences, by stipulating in their models that, for example, work effort has negative utility, money rewards have positive utility, and individuals have no other relevant motivations Two outstanding problems: 1. The first of two outstanding problems stems directly from the tendency among game theorists to black-box all questions of motivation Theoretical strategy does allow them to sidestep disputes over altruism and egoism, it also leaves them without a developed theory of preference formation, and thus without an ability to model the way that preference changes arise out of social interactions There is nothing intrinsic to agency theory that prevents people from taking interest in the way that internal incentives such as preference change can be used to overcome agency problems; it is just that game theorists have no idea how to model such processes, and so chose to ignore them 2. The second outstanding problem involves commitment on the part of the agency theorist to the view that individuals will behave opportunistically whenever given the chance to do so Two components of opportunism n the standard sense of the term o Taking advantage of circumstances as they arise o Acting without regard for principle Opportunistic behaviour: direct consequence of agents acting in accordance with the general game theoretic principle known as sequential rationality Consequentialism postulate: value of an action is a function of its anticipated consequences, and nothing else (commitment to reoptimization follows almost immediately from this consequentialism) o Possibility that rational agent might incorporate deontic constraints – principles associated directly with actions, independent of their consequences – into his deliberation AGENCY THEORY AND SHAREHOLDER PRIMACY Pure agency relationship: relationship between stockholders and the managers of a corporation o Positive claim about the structure of the firm, not a normative claim about how the firm should be organized o Creates ambiguity concerning who is the agent and who is the principal Incentive theory: principle is the individual whose welfare is to be served and this welfare is affected by an agent who makes decisions on behalf of the principal o Principle is the one whose welfare ought to be served; agent is the one who is under an obligation to serve the principal faithfully
FIN800 Ethics in Finance
Normative stakeholder theory would regard to say that manager is suppose to advance interests of shareholders, to the exclusion of other constituency groups; but managers have no explicit contract with shareholders, nor do they stand in fiduciary relationship with them
AGENCY THEORY AND MISPLACED LOYALTY Another line of objection to agency theory is centered upon the claim that agency relationships, even fiduciary relationships, cannot serve as genuine source of moral obligation; rather, they serve only to transmit moral obligations from one person to another Either agent’s where agency relationship has nothing to do with it and action is ethical where the source must be traced back to some obligation imposed upon the principal; or unethical and agency relationship serves only to obscure that fact, by suggesting that it was done out of loyalty or obligation to the principal Nemo dat principle: nobody gives what he doesn’t have o Agency relationships is unable to create moral permissions where previously none existed o Acting for another does not give one ethical license and that all persons are ethically responsible for their actions, whether performed under command or performed on behalf of another Professionals role can serve as genuine source of moral obligation in that they can transform actions that are merely permissible for the principal into ones that are obligatory for the agent WHAT’S THE PROBLEM? Three potential problems with agency theory from the perspective of business ethicist: 1. Treats all motivation as self-interested 2. Presupposes shareholder primacy 3. Encourages violation of the nemo dat principle Standard defence of agency theorist will be to say that this is all just positive theory; no one is recommending universal opportunism Flawed conception of human rationality is agency theory generates predictions that are at variance with what one can actually observe in the behaviour of individuals and structure of organizations Improper Understanding of Incentives When agency problems do not show up where agency theory predicts that they should, rather than concluding there must be some relevant sort of internal constraint at work, these theorists assume that external incentives must be there, but that they simply have not been discovered Efficiency wage phenomenon: notion that a “fair day’s work is a fair day’s pay pays” a powerful role in determining employee effort level o Efficiency effects of wage increase can be explained entirely through reference of traditional monetary incentives, and without appeal to any obscure internal motivational factors, such as sense of fairness or commitment to reciprocity Framing effect: when translated into practical managerial decision making, might result in mistaken solutions to problems or even incorrect assessments of the problem to be solved Other potential source of mischief is caused by the assumption that, whenever a particular sort of agency cost fails to arise, there must always be an explanation in terms of external incentives Crowding Out of Moral Incentives Crowding out of moral incentives: pecuniary incentives can have the effect of undermining moral incentives o If reward being offered fail to outweigh the free-rider benefits, then the incentive scheme may easily have the effect of undermining cooperation, thereby creating real collective action problems Internal and external incentives are not necessarily complementary or cumulative, even when in theory they are correctly aligned to promote the same outcome Cryptonormativism Normative theory of practical rationality: one that categorizes certain forms of action as rational and certain other forms as irrational The fact that moral rules get categorized with models of irrational, and opportunism as rational, might easily lead more impressionable minds to the conclusion that they should learn to ignore moral constraints Two pernicious consequences 1. In acting more rationally, individuals may begin to plan their own behaviour in accordance with the dictates of instrumental model, and thus begin to act more opportunistically
FIN800 Ethics in Finance 2.
Even if they do not change their own deliberative processes, they may begin to expect higher levels of opportunistic behaviour from others, and therefore feel justified in engaging in pre-emptive defection in order to protect themselves from anticipated defection of others
