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Unformatted text preview: Agency Theory Outline
Introduction to game theory Agency theory in and insurance context Agency theory in an employment context Implications for accounting Solutions to moral hazard problem Agency theory in a loan context
2 1 Introduction to Game Theory
A non-cooperative game: Prisoners Prisoners' Dilemma Prisoner 2 Silent Prisoner 1 Silent Rat -1 , -1 0 , -4 Rat -4 , 0 -3 , -3
Prisoner 2's payoff Prisoner 1's payoff
3 Introduction to Game Theory Manager-investor in a non-cooperative g g p game Manager Honest Buy Investor Not buy 35, 20 35,30
Manager's payoff Distort 20,80 60, 40 Investor's payoff
4 2 Key Ideas From Game Theory Individuals act in their self interest. Mutually beneficial outcomes are often not attainable if people cannot
observe each other co-ordinate and commit to actions. 5 Agency Theory
Agency theory is a branch of game theory that studies the design of contracts to motivate a rational agent to act on behalf of a principal when the agent's interests would otherwise conflict with those of the principal.
Principal Employee contract E l t t Lending contract Shareholder Sh h ld Bondholder Agent Manager M Manager 6 3 Agency Theory Insurance Context
Why do you buy insurance?
If not required by law or your bank, would you buy insurance? Why is the insurance company willing to insure you? Does insurance influence your driving habits? Ideally, what would the insurance company like to do to reduce the chances of you getting into an accident? What roles do insurance deductibles serve? Why do insurance rates when you are at fault, receive speed tickets?
7 Insurance II 8 4 The Principal/Agent Problem
Agent (manager) is hired for his/her expertise.
He/she is risk-averse. Results of his/her effort (net income, l f hi /h ff ( i stock price) goes to the k i ) h principals (shareholders) Both parties are self-interested. Shareholders cannot monitor manager's input (effort). To induce the manager to work hard, his/her pay needs to be sensitive to performance (output). (output)
This imposes risk on the manager. A fixed salary reduces the risk imposed on the manager.
9 Principal/Agent II Unattainable best outcome: manager is paid fixed salary only, yet works as hard as he/she can. only can Actual solution: manager's pay is partially sensitive to performance (i.e., is risky) and works less hard than the maximum. 10 5 Implications for Accounting Outcomes are measured, not effort/input.
Manager can distort the reported outcome. A reliable measure of output is preferred by both parties.
Shareholders prefer less flexible accounting; would pay less per unit of output if report is more flexible flexible. 11 An Illustration - Payoff Table
Agent's Effort a1- work hard Outcome High Low Payoff $100 $50 Prob 60% 40% a2 - shirk Payoff $100 $50 Prob 30% 70% Does this compensation plan induce high effort (a1)? 12 6 Solutions to the Principal/Agent Problem 1. 2. 2 3. 4. 5. 6. Pay a fixed salary. Directly monitor agent. agent Indirectly monitor the agent. Sell/rent company to agent. Use risk/profit sharing arrangement. y g good Rely on agent's desire to maintain a g reputation. 7. Principal diversifies his portfolio. 13 Direct monitor- Payoff Table Agent's Effort a1- work hard Outcome High Low
14 a2 - shirk Payoff $40 $40 Payoff $100 $100 7 Shareholder Creditor Conflict
Creditors supply funds to corporations.
Don't have control over funds once lent. Will they get their money back, with interest? back Creditors need to protect themselves.
Charge a higher interest rate. Fewer borrowers, fewer projects undertaken, lower profits for lender. Solution--use restrictive covenants to:
limit the range of activities of the company g p y limit the exposure to loss. Lenders require audits to verify financial results OR Companies volunteer to have audit performed on their F/S.
Self-interest of managers, shareholders, and creditors leads to conflict. Conflict is resolved by using risk-sharing arrangements that make the agent's payoffs sensitive to outcomes. Management has the ability to manipulate the reported outcomes. Financial statements need to be reliable--resilient to manipulation. Conservatism counteracts exaggeration.
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- Spring '09