Lecture Notes: Agency Theory

Introduction to Agency Theory

• Definition: A concept explaining the relationships between principals (e.g., shareholders) and agents (e.g., company executives).
• Key Issue: Conflicts or disagreements can arise because principals rely on agents to make decisions.
• Example Conflict:
  • Executives may focus on short-term profitability, risking long-term shareholder interests.

Section 1: What is Agency Theory?

• Agency Relationship: Comprises two parties, the agent and the principal.
  • Agent: Represents the principal, making decisions and using resources on their behalf.
  • Principal: Bears the risks of the decisions made by the agent.
• Complications: Disputes, disagreements, and conflicts of interest.
• Objectives of Agency Theory: Organize relationships to prevent conflicts.
• Key Assumptions:
  1. Individuals act in their own self-interest.
  2. Agents have more information and decision-making power.

Section 2: Principal-Agent Relationships

• Type 1: Shareholders and Management Teams
  • Management may take higher risks for potential gains, misaligned with shareholders' conservative risk appetite.
  • Compensation structures (stock options) can heighten this conflict.
• Type 2: Investors and Fund Managers
  • Potential conflicts when fund managers prioritize personal gains over client interests.
  • Incentives may lead to biased decision-making.

Section 3: Real-World Examples

• Example 1: Enron Scandal
  • Enron hid losses using complex accounting, leading to bankruptcy in 2001.
  • Key players faced criminal charges.
• Example 2: Bernie Madoff Ponzi Scheme
  • Madoff’s scheme lacked oversight, leading to massive investor losses.
  • He was sentenced to 150 years in prison, illustrating agency theory failures.

Section 4: Strategies to Mitigate Agency Problems

1. Contracts
   • Detailed agreements specifying incentives, evaluations, compensations, and regulatory measures.
2. Restrictions
   • Limits on agent authority to minimize potential agency loss.
3. Evaluations
   • Performance-based evaluations to reward or sanction agent behaviors.
4. Bonuses
   • Incentives to align agent decisions with principal interests.
5. Transparency
   • Open communication to reduce conflicts and improve decision-making.

Section 5: Summary

• Core Idea: Agency theory helps understand principal-agent relationships and potential conflicts.
• Fundamental Assumptions: Egoism and information asymmetry.
• Strategies: Contracts, restrictions, evaluations, bonuses, transparency.

• Conclusion: The lecture provided insights into agency theory's relevance and mitigation strategies.
• Further Engagement: Questions and feedback are encouraged.