Agency theory and agency costs in organizational economics

Agency Theory

What activities should we look for in order to determine if an entrenched management is taking actions that would harm us as shareholders?

Agency theory highlights the fact that in some situations, agents, or individuals acting on behalf of other people's interests, like managers, may shirk their responsibility to the organization and put their own interests first, in the absence of incentives to do otherwise. "Adverse selection is the condition under which the principal cannot ascertain if the agent accurately represents his ability to do the work for which he is being paid. Moral hazard is the condition under which the principal cannot be sure if the agent has put forth maximal effort" ("Agency theory framework," 1997, Babson College). An example of adverse selection might be an office where employees surf the Internet all day, when they are supposed to be doing work. An example of moral hazard might be that of a store manager who promotes friends and relatives who are less qualified than other potential employees, and blames the economic climate for poor store performance.

A poor market showing, in comparison to other competitors in the same industry might be a red flag for shareholders that managers are not doing a good job. A failure to explore R&D, but demanding further perks and salary increases might be another indication of poor management. Also, cronyism, or promoting individuals from the place of employment where the managers worked before, or in-house promotion without looking at more qualified individuals might indicate that mangers have an agenda beyond serving the shareholders.

2. Also how will these actions harm the stockholders?

Poor management can have catastrophic effects. First of all, a failure to take measures to ensure that the company remains competitive will result in a loss of profits, meaning that company shares will be worth less. Over the long-term, if the company is managed poorly and lags behind other competitor firms in the industry, the firm's reputation can be damaged, causing share prices to plummet. So can unethical actions by management, if they are publicized and impact the company's reputation. In extreme cases, managers might manipulate the price of stock to improve their own financial future, releasing falsely positive reports to net a gain, and then selling shares before the real truth about the company's poor financial health becomes known.

3. Finally what can be done to insure that we will have a greatly reduced probability of agency issues with the management of FF&F, Inc.

Linking pay to performance has been one popular way of remedying the problem of agency on an executive level. However, this is problematic to some degree, as outside factors can substantially impact short-term profitability. A bad manager might receive a bonus during times of economic boom, while a good manager instating needed reforms might oversee the company during a period of economic decline, or simply have to allow an initial loss to see a profit later on. Ensuring that managers are shareholders is another method of ensuring that the interests of the managers are in line with the company's interests, and therefore, shareholder's interests. However, there is always the danger of the CEO manipulating the company's apparent performance for his or her own interest, in that case.