Agency problems


It has long been recognized that the separation of ownership and control in the modern corporation results in potential conflicts between owners and managers. In particular, the objectives of management may differ from those of the firm’s shareholders. In a large corporation, stock may be so widely held that shareholders cannot even make known their objectives, much less control or influence management. Thus, this separation of ownership from management creates a situation in which management may act in its own best interest rather than those of the shareholders.

We may think of management as the agents of the owners. Shareholders, hoping that the agents will act in the shareholders’ best interest, delegate decision-making authority to them. Jensen and Meckling were the first to develop a comprehensive theory of the firm under agency arrangements. They showed that the principals, in our case the shareholders, can assure themselves that the agents (management) will make optimal decisions only if appropriate incentives are given and only if the agents are monitored. Incentives include stock options, bonuses, and perquisites (“perks�, such as company automobiles and expensive offices), and these must be directly related to how management decisions come to the interest of the shareholders.

Monitoring is done by bonding the agent, systematically reviewing management perquisites, auditing financial statements, and limiting management decisions. These monitoring activities necessarily involve costs, an inevitable result of the separation of ownership and control of a corporation. The less the ownership percentage of the managers, the less is the likelihood that they will behave in a manner consistent with maximizing shareholder wealth and the greater the need for outside shareholders to monitor their activities.

Some people suggest that the primary monitoring of managers comes not from the owners but from the managerial labor market. They argue that efficient capital markets provide signals about the value of a company’s securities and, thus about the performance of its managers.

Managers with good performance records should have an easier time finding other employment (if they need to) than managers with poor performance records. Thus, if the managerial labor market is competitive both within and outside the firm, it will tend to discipline managers. In that situation, the signals given by changes in the total market value of the firm’s securities become very important.

Social Responsibility

Maximizing shareholder wealth does not mean that management should ignore social responsibility, such as protecting the consumer, paying fair wages to employees, maintaining fair hiring practices and safe working conditions, supporting education, and becoming involved in such environmental issues as clean air and water. It is appropriate for management to consider the interests of Stakeholders other than shareholders. These stakeholders include creditors, employees, customers, suppliers, communities in which a company operates, and others. Only through attention to the legitimate concerns of the firm’s various stakeholders can the firm attain its ultimate goal of maximizing shareholder wealth.

Many people feel that a firm has no choice but to act in socially responsible ways. They argue that shareholder wealth and, perhaps the corporation’s very existence depend on its being socially responsible. Because the criteria for social responsibility are not clearly defined, however, formulating consistent policies is difficult. When society, acting through various representatives bodies, establishes the rules governing the trade-off between social goals and economic efficiency, the task for the corporation is clearer. We can then view the company as producing both private and social goods, and maximization of shareholder wealth remains a viable corporate objective.