At the beginning of the 20th century, the growth of companies and their new form of management led to many large corporations being run by agents who did not own the companies’ assets. Thus began a conflict of interest between the proprietary and managing agents that persists today. The authors Berle & Means (1932) y Coase (1937) identified the agency problem, also known as agency theory, in business management.
The agency problem tries to explain the conflicts that occur when there are agents who own the business while other agents have the responsibility to act on assets that they do not own; that is, they make decisions about assets that do not belong to them, trying that their eventual decisional errors will not affect their interests.
When the managing agents are the business owners, agency problem does not exist. The manager is deciding on his assets. However, when the manager decides on other people’s assets, he does not endanger his properties or private interests, which, on occasion, means that the manager makes decisions to improve his interests to the detriment of the organization’s interests.
We might think the agency problem would be solved by assigning ownership of the assets to each decision-maker. On the other hand, from the business perspective, it is understood that the company concept would disappear since each manager would become the owner of his means of production, fragmenting the company as such, which would lead to its disappearance. It is a similar situation to pre-industrial artisans, who owned their own means of production (tools), and although they were grouped in guilds, they did not constitute companies.
The theory considers that the agency problem cannot be eradicated. Therefore, the objective of studying the problem is to minimize it as much as possible.
The main reason why the agency problem cannot be completely eliminated is that in the company, some agents have ownership (shareholders) or have hierarchical authority (managers), while other agents have the competence or knowledge to carry out tasks or decide within their authority (technicians). It is very difficult for a single agent to combine all these capacities.
- The owner or shareholder has the right over the residual (in case of liquidation of the company, once the shareholders are paid, what remains belongs to the property) or over the profit generated.
- Agents with hierarchical authority have decision and control rights. For example, specific bodies, such as the Board, are created in a PLC to exercise the right of control.
- The technicians, specialists, and employees (staff) have the right of execution; they execute activities by what are called executing agents.
Types of agency problem
Managers decide on assets that are not their own. The decisions are oriented to improve their private interests
The executors (technicians – staff) manage the means of production and knowledge, directing it to improve their private interests as well.
The agency problem studies
Berle & Means (1932)
Given the expansion that took place at the beginning of the 20th century, the agency problem arises; in large companies, it is unknown who owns it.
For example, the partner of a PLC diversifies its risk by investing in different companies, so it has no interest in controlling any of them in particular. Also, since he is not a manager, he does not know how to control it.
So, who manages? What interests pursue these managers or directors? These authors observed that most managers pursue their own interests because there is discretion in the management function since they have a wide margin of maneuver to favor themselves.
The manager does not seek to maximize the value of the company (which is what the property pursues) but instead seeks to maximize the size because this entails a series of advantages and payments that he perceives at the rate of said size. Here is the agency problem: the agent seeks his own interest and not that of the property or principal.
It is observed how there are agency problems in all the hierarchical scales of the company. We can ensure that the agency problem runs vertically throughout the hierarchical organization chart.
Another agency problem is a consequence of knowledge.
Knowledge distributed among agents is specific knowledge or knowledge of particular circumstances of time and place. It is specific to decisions that must be adopted; it is not knowledge that can be transmitted to the upper echelon so that it can make decisions. The specialist knows the details in terms of applying the knowledge that one has to specific problems.
For example, we are presented with two options when we have to decide on production:
- Delegate to the engineer who knows the details. Possibly do the right thing, but in the direction that interests him most.
- Ask the engineer for details to tell him what to do from above. The agency problem does not exist in this case, but the inefficiency problem appears.
Thus, we will have to choose between inefficiency costs and agency costs.
We will try to reduce the agency cost to zero, minimizing it as much as possible. But if we incorporate inefficiency costs, we must allocate them to the product because they are very difficult to fix later. Generally, it is usually more interesting to incur agency costs and try to minimize them later.
Proposals to minimize the agency problem
Sometimes the agency problem between directors and property can be resolved by filing a Board of Directors with external directors in its composition and internal directors, who can be controlled by senior management and property.
From the theory, an attempt is made to guide the behavior of the agents toward what is correct through four proposals:
- Through the organizational design: organizational chart, indicators, review and control systems, direct supervision and standardization of processes (formalization and centralization).
- Through financial and accounting instruments: analytical cost accounting, for example.
- Alignment or ordering of incentives, so that they are aligned according to the objectives that are intended to be achieved (Application of the HR theory and the economic theory of the company)
- The institutional design of the organization (institutional form or organizational form). Through the institutional design, it is possible to: (a) delegate the right of decision and (b) minimize the agency problem.
Companies seek the best way to control their assets and be efficient through institutional design. There are two options for setting up a company in a way that minimizes the agency problem:
Residual Rights - Control rights - Decision rights
Residual rights - Control rights - Decision rights
It is often claimed that the best way to delegate decisions to those who know, reducing inefficiencies and agency problems, is through separating residual rights of decision and control.
Failures in control systems
Control through the Board of Directors is a system that is often contaminated. The directors of a Board of Directors are not independent of the directors and are exposed to two sources of contamination:
- Inevitable and necessary: there are Board members who are directors
- Inevitable and undesirable: the external directors have come to the Board through personal relationships, friendships, knowledge, etc., so they have a relationship with some of the directors. In this way, the total independence of the Board to evaluate the internal directors is not presented.
Even with the deficiencies explained, to illustrate the importance of control bodies, such as the Board, one of the solvency criteria of a country is the number of external directors in anonymous companies.
Detractors of agency theory
Donaldson & Davis (1991) are contrary to the postulates of the agency theory. Donaldson raises the figure of the “faithful servant” or agent who does not deviate. These authors argue that better performance depends on better control and cooperation.
Jensen responds that even if we have loyal servers, they will have different perceptions of the organization, so the agency problem will continue to arise, and there will be a need for control. Jensen is not opposed to the “faithful servant” figure but suggests that, if it exists, the agency problem does not disappear but must be reduced through organization and adequate controls.
Limitations of the agency model
In any case, no system we can propose to reduce the agency problem is infallible. The agency problem is a human factor problem so no model can guarantee the good behavior of all agents in all situations.
In agency problem, as in any other theory, perfect models do not exist because reality is infinite, and we cannot encompass or explain infinity from a finite model.
Donaldson, L. and Davis, J.H., 1991. Stewardship Theory or Agency Theory: CEO Governance and Shareholder Returns. Australian Journal of Management, 16, 49.