L07Agency - Agency Theory A. Introduction Agency theory...

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Agency Theory A. Introduction Agency theory studies the design of contracts to motivate a rational agent (manager) to act on behalf of a principal (owner/shareholder) when the agent's interests would otherwise conflict with those of the principal. Agency theory primarily involves the moral hazard form of information asymmetry. That is, the key feature in agency theory is that the actions of the agent are not observable to the principal. This theory originates in the context of insurance. Most of you are to some extent familiar with car insurance, if not home insurance. Thinking about insurance will help you to understand agency theory. Think about the following issues with respect to buying car insurance. Why do you buy insurance? If insurance is not required by law, would you buy it anyway? Why? Why is the insurance company willing to insure you? Will your driving habits differ if you had insurance or not? What would the insurance company like to do, but can’t, to minimize costs of damages? Insurance policies have deductibles. What role do they serve? Why do your insurance rates go up when you are at fault for an accident or when you receive tickets for moving violations (but not for parking violations)? B. The principal/agent problem While the same model helps to explain both car insurance and the relationship between owners and managers, the way to think about the problem is somewhat different. Insurance begins with the desire to share risk , with the side effect of the insured driver taking less precautionary effort . In contrast, the owner/manager problem begins with the need to motivate effort from the manager, with the result that some of the firm’s risk is shared with him/her. Below is more detail on how this works. 7-1
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1. One or more owners/shareholders hire a manager to operate their company. One reason they hire the manager is that he/she has management expertise. 2. The agent is risk-averse so that he/she does not desire to buy the company from the shareholders. 3. Both the agent and the principals are self-interested. 4. The consequences of the agent's work/effort are realized to the principal, not the agent. That is, shareholders receive the profits and bear any losses of the firm.
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L07Agency - Agency Theory A. Introduction Agency theory...

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