Agency Theory as a Basis for Business Ethics Presented to the Christian Business Faculty Association October, 2000 Dennis Proffitt Professor of Finance Grand Canyon University P.O. Box 11097 Phoenix, Arizona 85061-1097 telephone: 602.589.2822 e-mail: [email protected] July, 2000 Preliminary Version – Please Do Not Quote
2 Agency Theory as a Basis for Business Ethics Since the publication of Jensen and Meckling's seminal work in 1976, agency theory has become an important part of modern financial economics. Almost every introductory textbook in the field of corporate finance mentions agency theory and the existence of agency problems in its introductory chapter. It is commonly cited as one of the key areas in the development of modern financial thought. 1 Its principles have been extended provide explanations of merger activity and corporate restructuring, dividend policies, executive compensation, the composition of corporate boards, and capital structure, among other issues. Agency theory defines the firm as a "nexus of contracts" between different resource suppliers. Two parties are central to agency theory; principals, who supply capital, and agents, who manage the day to day affairs of the firm. Since the interests of the agents are not necessarily those of the principal, the organization encounters agency costs. These costs consist the expenses of monitoring the behavior of agents, including budget restrictions, compensation practices (including stock options, bonuses, and other incentives), and the loss of profits due to operating rules and restrictions on management. They also include bonding costs of the agents, and the costs of sub-optimal decisions, defined as decisions that are made in the bests interests of agents rather than principals. 1 See, for example, Weston, J.Fred. "A (Relatively) Brief History of Finance Ideas" Financial Practice and Education (vol. 4, no.1,) Spring/Summer, 1994, pages 7-26; also Horrigan, James O. "The Ethics of the New Finance" Journal of Business Ethics (vol. 6, 1987), pages 97-110; also Jensen, Michael C. and Clifford Smith, "The Theory of Corporate Finance: A Historical Overview" The Modern Theory of Corporate Finance (McGraw-Hill, 1984), pages 2-20.
3 Agency theory assumes that self-interest motivates all parties, both principals and agents. Self-interest is defined as maximization of the utility of personal wealth. In making this assumption, Jensen and Meckling make no assertion about its morality. Rather, they simply claim that it is the best descriptor of human motivation. Nevertheless, this assertion generates a great deal of criticism in the literature of financial ethics. There are also ethical implications in agency theory's definition of the firm as a "nexus of contracts." Jensen and Meckling state that this definition avoids the "personalization" of the firm as a whole, and places the responsibility for the firm's actions squarely on the shoulders of the agents who made the decisions. Critics of the definition feel it de-emphasizes the role of ethics in the development of corporate policies and promotes a "value-free" practice of financial decision making.
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