Agency Theory Summary Delves Patrick
Agency Theory Summary Delves Patrick
An agency relationship is one in which “one or more persons (the principal[s]) engage another
person (the agent) to perform some service on their behalf which involves delegating some
decision making authority to the agent”1 Perhaps the most recognizable form of agency
relationship is that of employer and employee. Other examples include state (principal) and
Agency theory is the study of the agency relationship and the issues that arise from this,
particularly the dilemma that the principal and agent, while nominally working toward the same
goal, may not always share the same interests. The literature on agency theory largely focuses on
methods and systems—and their consequences—that arise to try to align the interests of the
principal and agent. While the agent/principal dilemma in a corporate context had been pondered
as early as the 18th century by Adam Smith3—and many of its key concepts were developed in
literature on the firm, organizations, and on incentives and information4—a separate theory of
agency did not emerge until the early 1970s when Stephen A. Ross and Barry M. Mitnick,
1 Meckling, William H. and Jensen, Michael C., Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure (July 1, 1976). Michael C. Jensen, A THEORY OF THE FIRM: GOVERNANCE,
RESIDUAL CLAIMS AND ORGANIZATIONAL FORMS, Harvard University Press, December 2000; Journal
of Financial Economics (JFE), Vol. 3, No. 4, 1976.
2 Mitnick, Barry M., Fiduciary Rationality and Public Policy: The Theory of Agency and Some Consequences
(1973) , p. 2
3 “The directors of [joint-stock] companies, however, being the managers rather of other people’s money than of
their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which
the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt
to consider attention to small matters as not for their master’s honour, and very easily give themselves a
dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the
management of the affairs of such a company.” – The Wealth of Nations, 1776.
4 Mitnick, Barry M., Origin of the Theory of Agency: An Account By One of the Theory's Originators (January
2006), p. 5
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Ross presented his paper entitled The Economic Theory of Agency: The Principal's
Problem5 at the annual meeting of the American Economic Association in December 1972. This
paper outlined agency as a universal principle and not just a theory of the firm. Even so, the
rather brief paper limited its scope to the problem of incentive and laid out a model for inducing
By contrast, Mitnik's paper6, entitled Fiduciary Rationality and Public Policy: The
Theory of Agency and Some Consequences and presented at the annual meeting American
Political Science Association in 1973, laid out a much more general theory of agency with
possible application to numerous societal contexts. Mitnick identified the problems of agency as
1) the principal's problem, 2) the agent's problem, 3) policing mechanisms and incentives. The
principal's problem is to motivate the agent to act in a manner that will achieve the principal's
goals. Examples of motivational tools are financial incentives, prospect of sanctions, and
supplying information to activate norms (such as loyalty or obedience) and preferences that
coincide with the principal's goals. The agent's problem is that he may be faced with decisions to
act either in the principal's interest, his own interest, or some compromise between the two when
they do not coincide. Policing mechanisms are mechanisms and incentives intended to limit the
agent's discretion, such as surveillance or specifically directed tasks. Incentive systems are
mechanisms that offer rewards to the agent for acting in accordance with the principal's wishes,
such as bonuses and increased pay (positive incentives) or fear of reprisals (negative incentives).
The problem with policing and incentives is that they create costs for the principal; this creates a
5 The American Economic Review, Vol. 63, No. 2, Papers and Proceedings of the Eighty-fifth Annual Meeting of
the American Economic Association (May, 1973), pp. 134-139
6 Paper presented at the 1973 Annual Meeting of the American Political Science Association, New Orleans, LA.
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potential paradox in that it is only rational to implement policing and incentive mechanisms if
the increased return to the principal's objective outweighs the cost of policing and incentives.
Mitnick concluded by noting that he had created only a basic framework around which to further
In 1976, Michael C. Jensen and William H. Meckling did just that with their seminal
paper Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.7 As
part of a broader theory of the firm, this paper further explored agency costs and its sources. Like
Mitnick, Jensen and Meckling identify monitoring the agent's actions as a source of agency cost,
but they also identify at least two other sources: bonding costs borne by the agent (such as
bonding against malfeasance, contractual limitations on his power, which limits his ability to
take full advantage of profitable opportunities, foregoing certain nonpecuniary benefits, etc.),
and the wealth loss borne by the principal when the agent's actions do not maximize his welfare
(referred to as “residual loss”). While the previous agency theory literature had focused on how
to structure incentives and the principal/agent relationship to maximize the principal's welfare,
Jensen and Meckling presume the parties largely resolve these issues. Instead Jensen and
Meckling “investigate the incentives faced by each of the parties and the elements entering into the
determination of the equilibrium contractual form characterizing the relationship between the
manager (i.e., agent) of the firm and the outside equity and debt holders (i.e., principals).”
To that end, they compared the management behaviors found in two different firm structures:
one where the manager owns 100% of the firm versus when the manager sells an equity share to
outsiders. In the former structure, the owner/manager will act to maximize the firm's welfare because
the full benefit of this maximization will accrue to him. Maximization occurs when the marginal
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utility of each dollar expended is equal to the nonpecuniary benefits (such as office size and
appointments, respect from staff, ability to choose and control staff, etc.) and the marginal utility of
each after-tax dollar. However, when the owner/manager sells, say, a 20% equity stake to outside
shareholder, agency costs will arise from the divergence of interests between the manager and the
shareholders. For instance, since his wealth interest has been reduced to 80%, he will be inclined to
expend resources such that one dollar spent equals the marginal utility of 80 cents of purchasing
power— a reduction equal to his reduction in the share of the wealth. This cost can be mitigated, but
probably not eliminated, by the shareholders incurring monitoring costs. As the manager's fractional
ownership falls, his fractional outcome on ownership falls as does his incentive to seek out new
profitable ventures; and his incentive to extract rents or perquisites rises, as do the monitoring costs
to curb such tendencies. Jensen and Meckling conclude that these agency costs are inevitable when
there is a separation of ownership and control, and that to call these costs “inefficiencies” is
appropriate only if comparing to an “ideal world” where principal and agent interests could be
Jensen and Eugene F. Fama further explored the separation of ownership and control in
19838, particularly in large, complex organizations. Central to their paper Separation of Ownership
and Control is the theory of how decision processes are divided. Generally speaking, the decision
8 Fama, Eugene F. and Jensen, Michael C., Separation of Ownership and Control. Michael C. Jensen,
FOUNDATIONS OF ORGANIZATIONAL STRATEGY, Harvard University Press, 1998, and Journal of Law
and Economics, Vol. 26, June 1983.
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Fama and Jensen hypothesize that because the decision managers in such organizations do not bear
the major wealth effects of their decisions, an effective system “implies, almost by definition, that the
control (ratification and monitoring) of decisions is to some extent separate from the management
(initiation and implementation) of decisions.” The control decisions tend to be retained by those who
Fama and Jensen test this hypothesis by examining the decision structures of four types of
large, complex organizations: open corporations, large professional partnerships, financial mutuals,
and nonprofits. In open corporations, common stockholders can exercise control by way board
selection or ability to sell stock and thus affect the stock price. But shareholders have virtually no
role in the day-to-day management of the corporation, which is instead carried out by the executives.
Thus the nature of an open corporation provides near-perfect separation of control and management.
For partners in large professional organizations, their welfare as residual claimants depends
on the actions of other residual claimants over which they have little direct control. For this reason,
independent board. Additionally, the sharing of liability among fellow partners “ensures that large
partnerships have strong versions of the mutual monitoring systems that [Fama and Jensen] contend
are common to the decision control systems of complex organizations” with diffuse residual claims.
For financial mutuals, the residual claimants are customers (depositors, policyholders, mutual
fund holders) who generally do not participate in the day-to-day management processes. The residual
claimants exercise control by their ability to withdraw assets from the mutual at any time and deprive
management of control over those assets. Mutuals also feature a board of directors, though their role
is less important than that of an open corporation due to the inherent decision control of the
For large nonprofit organizations, the capital is largely supplied by donors who lack the
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control inherent in the ability to withdraw or alienate assets as in open corporations and financial
mutuals. Additionally, since donors do not expect a financial return on their investment, agency
problems between donors and management are substantially minimized. Nonetheless, donors
typically want some assurance that the management will not expropriate their donations for uses
other than as the donors intended. Like other complex organizations, nonprofits typically have a
board of directors whose primary function is to exercise decision control. Because nonprofit board
members are often substantial donors themselves, they stand in as the residual claimants with
decision control. This gives other current and potential donors some measure of comfort that the
In 1990, Jensen and Kevin J. Murphy examined incentives behind CEO pay. The upshot of
their conclusions can be found in the title of their paper: CEO Incentives—It’s Not How Much You
Pay, But How.9 Jensen and Murphy gathered compensation data for 2,505 CEOs of 1,400 publicly
traded companies from 1974 through 1988 and for executives at over 700 companies from 1934
through 1938. They also collected stock ownership data for the CEOs of the 430 largest corporations
in 1988. After compiling and analyzing the data, they arrived at the following conclusions.
1. Contrary to the prevailing belief at the time, executives are not receiving record salaries
and bonuses. From 1934 to 1938, the average annual CEO compensation (salary and
bonus) was $882,000 in 1988 dollars versus $843,000 for the period between 1982 and
1988.
2. Annual changes in executive pay do not reflect changes in corporate performance. For
the median CEO in the largest 250 companies, a $1,000 change in corporate value
equated to a change of 6.7 cents in salary and bonus over two years.
9 Jensen, Michael C. and Murphy, Kevin J., CEO Incentives: It's Not How Much You Pay, But How. Michael C.
Jensen, FOUNDATIONS OF ORGANIZATIONAL STRATEGY, Harvard University Press, 1998; Harvard
Business Review, No. 3, May-June 1990
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3. Compensation for CEOs is no more variable than compensation for hourly and salaried
employees. “A comparison of annual inflation-adjusted pay changes for CEOs from 1975
through 1988 and pay changes for 20,000 randomly selected hourly and salaried workers
took real pay cuts over this period than did production workers.”10
4. With respect to pay for performance, CEO compensation is getting worse rather than
better. As a percentage of total shares outstanding, CEO stock ownership was ten-times
While the general public was focused on the level of executive pay, Jensen and Murphy
contended that the method of pay was inadequate to attract top talent and shape executive
behavior to maximize shareholder value. The solution to this problem, according to Jensen and
requiring a higher level of stock ownership among executives, and structuring bonuses and stock
options to reward success and penalize failure; and 2) more dismissals of poorly performing
executives—two studies of 500 CEOs over 20 years found only 20 cases where the CEO left
Where stock ownership is concerned, what matters is not the dollar value of the stock the
CEO holds but the percentage outstanding stock he owns. The higher the percentage, the tighter
the link between shareholder wealth and CEO wealth (and, presumably, the more aligned their
Jensen and Murphy argue that cash compensation “should be structured to provide big
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rewards for outstanding performance and meaningful penalties for poor performance.”11 The
then 7-cent change in CEO pay for every $1,000 change in corporate value did not provide
sufficient motivation to perform well or avoid performing poorly. The advantage of cash
compensation is that it is not subject to the changes in corporate value caused by market
While Jensen and Murphy emphasize that direct stock ownership is the most important
component of increasing pay for performance, they note that stock options “are an increasingly
in shareholder value. The disadvantages to stock options compared to stock shares are that they
do not reward dividends and the change in the value of options is roughly 60 cents on the dollar
due to variables such as interest rates, dividends and whether the options are in or out of the
money.
By 2003, Murphy had struck a more pessimistic chord on stock options. Murphy, with
Brian J. Hall, wrote in The Trouble with Stock Options14 that “too many options are granted to
too many people.” From 1992 to 2002, the total value of options issued by S&P 500 companies
had grown from $11 billion to $71 billion after falling from a high of $119 billion in 2000. The
arguments in favor of stock options had been that 1) they give a greater incentive for executives
performance; 2) they attract highly motivated and entrepreneurial employees; 3) they allow
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employers to hire talent without a direct outlay of cash; and 4) they mitigate risk aversion by the
executives by encouraging risk-taking. But the Enron, WorldCom, Global Crossing, and other
corporate scandals have been linked to excessive risk-taking encouraged by stock options.
Moreover, these scandals ignited new debate over the reporting requirements for stock options,
which at the time were not required to be recorded as an expense unless the exercise price was
From 1992 to 2002, the value of stock option grants by S&P 500 companies increased
from $22 million per company on average to $238 million. By 2000, the average CEO
compensation had grown from $14.7 million from $3.5 million in 1992. Most of this increase
was due to an escalation in stock options values from 1992 to 2000. But not all of the stock
options flowed to executives. By 2000, nearly 10 million U.S. employees held stock options.
According to Hall and Murphy, this run-up in stock options was due to tax and
accounting rules favoring the issuance of options. In 1994, the Internal Revenue Code was
amended to limit the deductibility of cash compensation to $1 million each for the top five paid
options were not subject to this limit. Also, prior to 2004, companies were only required to report
the “intrinsic value” of stock options—and unless the exercise price is lower than its market
But are options efficient? Hall and Murphy argue the answer is no. First, most stock
options are issued to non-executive employees, so much of the expense of issuing options does
not serve the purpose of aligning executive and shareholder interests. Second, the cost to the firm
15 Since the publication of Hall and Murphy's paper, the Financial Accounting Standards Board issued Financial
Accounting Standard 123R, which required publicly traded companies to report stock options as an expense on
their financial statements.
16 See note 15.
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of issuing stock options is greater than the value received by the recipient employees. The cost of
options is the amount an outside investor would pay for, assuming the same forfeiture risk and
vesting schedule. On the open market, this risk would be offset by a discount, but the recipient
employees are not afforded the presumption of a discounted value. Also, “for reasonable
assumptions about risk aversion and diversification, we find that employees value options that
have just been granted with an exercise price equal to the market price at only about half of their
cost to the firm. This value-to-cost ratio is substantially smaller if the options have an exercise
price that is above the existing market price, or if the exercise prices increases over time, or if the
option has a long vesting period.”17 Furthermore, stock options are a way of borrowing services
from employees for the prospect of future payouts, and risk-averse employees are not an efficient
source of capital. Additionally, since rank-and-file employees are not willing to pay close to full
price for their options, broad-based options are not an efficient talent-recruitment method
because they are not an attractive substitute for cash. And stock options are not always an
efficient method of retention. This is particularly true during bear markets when options are more
likely to be underwater and the lure of being issued “fresh” options by competing employers is
stronger. And finally, stock options are an inefficient motivator for most employees because only
a nominal portion of any increase in the value of the firm will flow through their options
holdings.
As a way of compensating top executives, Hall and Murphy prefer restricted stock to
options because options lose much of their incentive value if the market value falls sufficiently
below the exercise price, while restricted stock retains a higher incentive value because it will
nearly always be worth “something.” Also, an executive has an incentive to engage in riskier
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behavior if he holds options that are underwater than will an executive holding restricted stock
that still has present value. Executives with restricted stocks have a greater incentive to pursue
what Hall and Murphy call “appropriate dividend policy” because restricted stock can pay
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