UNIT 6- Agency Relation PDF

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UNIT 6: AGENCY RELATION 1. THE AGENCY PROBLEM An agency relation is a relationship between two people: Principal and Agent, who makes decisions behalf of the principal. The agent´s decisions affect the principal´s utility. The agent gives effort to the principal in order to receive a salary. EXAMPLES OF AGENCY RELATIONS: -The owner of a firm and the manager of a firm. -A manager and her subordinate. -A patient and her physician. -An insurance company and a person holding a fire insurance policy. An agency problem arises in organizations when: -There are conflicts of interests. The principal and the agent have different interests. It occurs because the principal´s desire of agent´s effort is lower than the agent´s effort: e*< e. The reason is that effort is costly, so agent offers less effort. -There is asymmetric information between the agent and principal. In other words, the agency problem is moral hazard. As a consequence of conflicts of interests and asymmetric information, it will be moral hazard: the worker will offer less effort. 2. SOLUTIONS FOR AGENCY PROBLEMS IN ORGANIZATIONS There are two solutions to resolve agency problems: A) Align the interests of the agent to the interest of the principal. In other words, reduce the gap between the interests of principal and agent. This can be done by: -Offering the agent an incentive contract. In organization the typical one is pay for performance: Pay= a+b*Perfomance Meassure. The principal is going to monitor the performance of the agent. -Hiring or contracting agents who share the objectives of the principal. B) Improve observability. In other words, reduce asymmetric information between the principal and the agent. This can be done by monitoring effort directly. 3. THE SEPARATION BETWEEN OWNERSHIP AND CONTROL (LARGE PUBLIC CORPORATIONS) If we put our attention on the ownership structure in firms, we can distinguish between:  MANAGER CONTROLLED FIRMS. They are companies whose shareholders don´t runt the business. So, there is a separation of ownership and control. Managers only own a small percentage of all shares.  OWNER-CONTROLLED FIRMS. They are companies whose shareholders run the business. There isn´t separation of owner and control. Managers own a significant percentage of all shares (family firms). The separation of ownership and control is the dominant feature of large corporations.

2 In companies with a separation of ownership and control, there is an agency relation between the shareholders and the company´s top manager or CEO.

In these companies the agency problem arises because: -The lack of agreement between the desires and objectives of the principal and the agent. -Moral hazard: The CEO´s behavior is unobservable by shareholders. ----------------------------------------------------------------------------------------------------------------------MORAL HAZARD: Is a hidden action problem. One part makes actions that the other part can´t see. It occurs after the transaction is made, after they agree to execute the transaction. EX: a driver with an auto insurance policy that provides full coverage, accident forgiveness, and no deductible may exercise less care while driving than someone with no insurance or a less generous policy because the first driver knows the insurance company, not him, pays 100% of the costs if he has an accident.

First Order Condition, FOC: Primera derivada. Incentive Compatibility Constraint, ICC: It occurs when the incentives that motivate the actions of individual participants are consistent with following the rules established by the group. Is important in interactions in which at least one participant does not know perfectly what another participant knows. Problems may arise when the participant with more information has an incentive to use that information for personal benefit at the expense of others. However, when the interaction is structured so that the participant with more information is motivated to act in the interest of the other party, the result is incentive compatibility. Restricción de Compatibilidad de Incentivos: Lograr que el agente revele con incentivos la verdadera información que oculta. Participation Constraint, PC: Ensures that the people want to participate. It says under what conditions will the agent participate with the agent.

PAY FOR PERFORMANCE Is one of the potential solutions of the agency problem in organizations.

3 The Pay For Performance aligns the interests of the agent and the principal. It can be used to solve different types of agency problems. Is recommend in environments in which effort monitoring is costly, therefore, you have to monitor a performance measure. PAY= a + b*PM a= fixed salary, firm´s profits b*PM= Variable component. b= parameter, commission

PM= performance measure

PM= PM(e). The Performance Measure measures perfectly the level of effort. If effort increases, the Performance Measure increases. So is good for the principal and the agent. 1) SOLVE THE AGENT PROBLEM -El agente busca maximizar su effort. Por eso la función depende de e. -Construir una función en función del effort: Maxe a + b(e) – c(e)= Maxe a + b*e – c(e) -First Order Condition or FOC: 1ª derivada. f´(e)= 0 + b – c´(e) -Optimizar (Igualar primera derivada a 0; ver si los puntos críticos son máximos (segunda derivada -) o mínimos (segunda derivada +): f´(e)=0  b=c´(e) -Sustituir todo lo que has averiguado en la función (b=c´(e); c(e) te lo dan).

2) SOLVE THE RPRINCIPAL PROBLEM -El principal busca maximizar el parameter or profit. Por eso la función depende de b. -Función en función de b: Maxb e – (a + b*e)  Maxb e – a – b*e Maxb PM*e – c(e) PROFIT= PM (Price of a goal or level of price for one effort) – COSTS (a+b*e) -Tiene algunas restricciones: -Incentive Compatibility Constraint or ICC. ICC: b= c´(e) -Participation Constraint or PC. PC= Pay= a + b*e  a+ b*e= c(e)  PC: c(e)= a+b*e -First Order Condition or FOC: (de/db= derivada de e respecto a b) f´(b)= PM de/db – c(e) de/db  f´(b)=0  de/db * (PM -c(e))=0 De aquí sacas el valor de la e, de/db no puede ser 0. CONLCUSION: b= c´(e) a+b*e= c(e)  a= c(e) -b*e...