2.2.4 Agency problems and costs

In more recent times Jensen and Meckling continued the research on the separation of ownership and control and the problems attached and they devised the agency theory. Jensen and Meckling define an agency relation as: "a contract under 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" (Jensen and Meckling 1976, p. 5).

These agency relations come into being due to the necessary separation of ownership and control: the investors (principals) have to engage managers (the agents) to manage their firm and delegate some of their decision-making authority to these agents. However, this principal-agent relationship is accompanied by agency problems: "Ifboth parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests ofthe principal" (Jensen and Meckling 1976, p. 5).

The interests of the principals and agents do not align. The shareholders (the principals) of a firm are interested in the capital return of their invested money (the share value). The managers (the agents) aim for a high salary, bonus or social status. This difference in interests is intensified by the above-mentioned information asymmetry between the managers and the shareholders (Akerlof 1970, p. 490). A manager usually has more information regarding the company and the relevant market than the shareholders and is not that willing to share his valuable information. He may use this information for his own benefits, to achieve his own goals. Whilst doing so he might take relatively high risks that could harm the shareholders and other stakeholders in the company. Acknowledging the controversial formulation, Williamson even states that agents can be described as opportunistic and self-interest seeking with guile (Williamson 1993, p. 97). Nevertheless, the interests of the agent do not align with the principal's and therefore it is of no surprise that the agent can behave in an interest-seeking manner (for some nuance and advanced understanding see below and section 2.3.1).

After having described the reasons for the existence of firms and the separation of ownership and control (see I in figure 2.1a), the remainder of the underlying section (and section 2.2.6 from a legal perspective) discusses the agency problems and coherent costs that occur due to the separation of ownership and control within firms (see II in figure 2.1a). Agency problems need to be minimised to make firms function properly and keep them in existence. Limiting the divergences in interests between the principals and agents can i.a. be achieved by establishing proper incentives for the agent to act in the interests of the principals (for instance a bonus linked to share value or profits). However, in this battle against agency problems (e.g. through the establishment of proper incentives and monitoring) costs must be incurred. Jensen and Meckling define those agency costs as the sum of:

According to Jensen and Meckling monitoring (i) includes more than just measuring or observing the behaviour of the agents. It includes efforts by the principal to control the behaviour of the agent, i.a. through audits, budget restrictions, compensation policies and operating rules. The costs attached to this monitoring can be named the monitoring (or structuring) costs. The agent also incurs costs as a consequence of the agency problems (ii); he aims for a good relationship with the principals. He makes sacrifices such as allowing control, representing the company in his free time or by having a salary partly subject to profit. The residual loss (iii) refers to the reduction in welfare experienced due to the divergence between the agent's decisions and the decisions that would maximise the welfare of the principal (Jensen and Meckling 1976, p. 5). Jensen modified the agency theory in 1994 and added an extra category to the agency costs: costs due to self-control problems (iv). Jensen points to the universal tendency of people to behave in non-rational ways (i.e. not behaving as a homo economicus). Human behaviour is dualistic; the behaviour has rational and non-rational components (Jensen 1994, p. 7). Due to the non-rational components agents take actions that harm themselves as well as the people around them, which results in agency costs as a result of self-control problems. Depending on the chosen remedies to solve or decrease the agency problems (see section 2.2.5) one or a combination of the agency costs mentioned above must be incurred.