ISSN - 2250-1991

Volume : 3 | Issue : 5 | May 2014

ECONOMICS

Research Paper

A Literature Review of Agency Theory

Shubhi Agarwal
Rohit Goel

ABSTRACT

Pushpendra Kumar
Vashishtha

RESEARCH SCHOLAR, DEPARTMENT OF ECONOMICS, CCS UNIVERSITY, MEERUT

ASSISTANT PROFESSOR, DESHBANDHU COLLEGE, UNIVERSITY OF
DELHI
ASSISTANT PROFESSOR, KAMLA NEHRU COLLEGE, UNIVERSITY OF
DELHI

Agency theory is a set of proposition in governing a modern corporation which is typically characterized by large number
of shareholders or owners who allow separate individuals to control and direct the use of their collective capital for future
gains. These individuals may not always own shares but may possess relevant professional skills in managing the corporation.
The theory offers many useful ways to examine the relationship between owners and managers and verify how the final
objective of maximizing the returns to the owners is achieved. This paper reviews the extensive literature of agency theory
along with some of its limitations and it also focuses that a firm can improve its performance if agency cost may be reduced.

KEYWORDS

Agency theory, Shareholders, Managers, Agency cost.

INTRODUCTIONA firm can be owned by a single person or by more than one

person. A firm owned by a single person is called a sole proprietorship concern. In this case the owner is the manager and
his interests are no different from that of the firm i.e., maximizing the firm value. But in majority of cases a single individual cannot provide the entire capital, expertise and resources;
and hence few individuals, with similar objective, collectively
carry out the business. A large number of investor provides
the risk capital. They are called shareholders. Shareholders
have the residual claim on the assets of the company. Therefore, the right to control the use of the assets of the firm vests
in them. They are deemed owners of the company. Shareholders delegate the power to manage the company to board of
directors. The board delegates the same to managers while
retaining its role to monitor and control the executive management. Corporate governance literature views shareholders
as the principal and manager as their agent and describes the
relationship as principal-agent relationshipAn agency relationship is defined as one in which one or
more persons (the principals) engage another person (the
agent) to perform some service on their behalf which involves
delegating some decision making authority to the agent. ( Hill
and Jones, 1992).
The divergence of interest between the owners and the managers, due to the separation of ownership from control, results in the agency costs.
Dealing with the agency problem is not free. Unfortunately,
there is an agency cost associated with coping with the agency problem. Agency costs usually fall under the category of
operating expenses. If employees of a company take a business trip and book themselves into the most expensive hotel
they can find or if they insist on the best computer in the
market for their offices, those are examples of agency costs.
Those things dont maximize the wealth of the shareholders
but instead minimize it.
LITERATURE REVIEW OF AGENCY THEORY- The agency
problem inherent in the separation of ownership and control
of assets was recognised as far back as in the 18th century

by Adam Smith in his Wealth of Nations, and studies such

as those by Berle and Means (1934) and Lorsch and Maclver
(1989) show the extent to which this separation has become
manifest in firms throughout the world. Under this agency relationship, both the agents and the principals are assumed to
be motivated solely by self-interest. As a result, when principal
delegates some decision making responsibility to the agents,
agents often use this power to promote their own well-being
by choosing such actions which may or may not in the best
interests of principals (Barnea, Haugen and Sanbet, 1985; Bromwich, 1992; Chowdhury, 2004). In agency relationship, the
principals and agents are also assumed to be rational economic persons who are capable of forming unbiased expectations
regarding the impact of agency problems together with the
associated future value of their wealth (Barnea et al., 1985).
Agency theory is concerned with the contractual relationship
between two or more persons. Jensen and Meckling (1976,
p.308) define agency relationship as a contract under which
one or more person (principals) 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 identify managers as the agents, who
are employed to work for maximizing the returns to the shareholders, who are the principals. Jensen and Meckling assume
that as agents do not own the corporations resources, they
may commit moral-hazards (such as shirking duties to enjoy
leisure and hiding inefficiency to avoid loss of rewards) merely to enhance their own personal wealth at the cost of their
principal. To minimize the potential for such agency problems,
Jensen (1983) recognizes two important steps1-The principal-agent risk-bearing mechanism must be monitored through the nexus of organization and contracts. The
first step, considered as the formal agency literature, examines how much of risks should each party assume in return for
their respective gains. The principal must transfer some rights
to the agent who, in turn, must accept to carry out the duties
enshrined in the rights.
2- The second step, which Jensen (1983, p. 334) identifies as
the positive agency theory clarifies how firms use contractual
monitoring and bonding to bear upon the structure designed
in the first step and derive potential solutions to the agency

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Volume : 3 | Issue : 5 | May 2014

problems. The inevitable loss of firm value that arises with the
agency problems along with the costs of contractual monitoring and bonding are defined as agency costs,(Jensen and
Meckling, 1976).
The principal-agent problem is also an essential element of
the incomplete contracts view of the firm developed by Coase
(1937), Jensen and Meckling (1976), Fama and Jensen (1983
a,b), Williamson (1975,1985), Aghion and Bolton (1992),
and Hart (1995). This is because the principal-agent problem
would not arise if it were possible to write a complete contracts. In this case, the investor and the manager would just
sign a contract that specifies ex-ante what the manager does
with the funds, how the returns are divided up, etc. In other words, investor could use a contract to perfectly align the
interests and objectives of managers with their own. However, complete contracts are unfeasible, since it is impossible to
foresee or describe all future contingencies. This incompleteness of contracts means that investors and managers will have
to allocate residual control rights in some way, where residual
control rights are the rights to make decisions in unforeseen
circumstances or in circumstances not covered by the contract.
Limitations of agency theory- There are a number of limitations of agency theory (Eisenhardt 1989; Shleifer and Vishny
1997; Daily et al. 2003):
Agency theory assumes complete contracts (i.e. contracts
that cater for all possible contingencies such as ambiguities in language, inadvertence, unforeseen circumstances, disputes, etc). Bounded rationality does not allow for
complete and efficient contracts. Information asymmetries,
transaction costs and fraud are insurmountable obstacles
to efficient contracting.
Agency theory assumes that contracting can eliminate
agency costs. The many imperfections in the market indicate that this assumption is not valid.
Third party effects are not recognised. Third parties are
those affected by the contract but who are not party to
the contract. Many boards are conscious of third party effects and adopt social as well as financial responsibilities.
Thus, whereas Maximum economic efficiency may (theoretically) be achieved under agency theory, it will not achieve
maximum social welfare.
Shareholders are assumed to be only interested in financial
performance.
Directors and management are assumed to owe their duty
to shareholders. The law requires that duty to be owed to
companies.
Boards have a number of roles. Agency theory may be suitable for the monitoring-of-managers role of boards, but it
does not explain the other roles of boards. Agency theory
is not informative with respect to directors resources, services and strategy roles.
Much of the corporate governance research is conceptualised as deterrents to managerial self-interest. Agency the-

ISSN - 2250-1991

ory treats managers as opportunistic, motivated solely by

self-interest. Many would argue that this theory does not
capture those who are loyal to their firms.
Agency theory does not take account of competence.
Thus, if even incompetent managers are honest (or are
made honest by board control) they will still be limited in their ability to meet shareholder objectives. It is not
enough to incentivise people to get a task done; they must
have the ability to carry out the task (Hillman and Dalziel,
2003).
CONCLUSION- As per the agency theory, due to the divergence of interests and objectives of managers and shareholders, one would expect the separation of ownership and control to have damaging effects on the performance of firms.
Therefore, one way of overcoming this problem is through
direct shareholder monitoring via concentrated ownership.
The difficulty with dispersed ownership is that the incentives
to monitor management are weak. Shareholders have an incentive to free-ride in the hope that other shareholders will do
the monitoring. This is because the benefits from monitoring
are shared with all shareholders, whereas, the full costs of
monitoring are incurred by those who monitor. These free-rider problems do not arise with concentrated ownership, since
the majority shareholder captures most of the benefits associated with his monitoring efforts. Several mechanisms can
reduce agency problems. An obvious one is managerial shareholdings. In addition, concentration shareholdings by institutions or by block holders can increase managerial monitoring
and so improve firm performance, as an outsider representation on corporate boards. The use of debt financing can improve performance by inducing monitoring by lenders. The
labour market for managers can motivate managers to attend
to their reputations among prospective employers and so improve performance. Finally the threat of displacement imposed
by market for corporate control can create a powerful discipline on poorly performing managers.
To conclude it can be said, if agency costs may be reduced in
the corporations, the firm performance can be improved.

REFERENCES
599-616,Barnea, A., Haugen, R.A., and Senbet, L.W. (1985). Agency Problems and Financial Contracting, New Jersey: Prentice. | Berle, A.A., and Means, G.C.,(1934), The
Modern Corporation and Private Property, New York: The Macmillan Company, 178-197. | Bromwich, M. (1992), Financial Reporting, Information and Capital Markets,
London: Pitman | Chowdhury, D. (2004), Incentives, Control and Development: Governance in Private and Public Sector with Special Reference to Bangladesh Dhaka:
Viswavidyalay Prakashana Samstha. | Daily,C.,Dalton,D.R.,andCannella, A.A. (2003) Corporate Governance: Decades of Dialogue and Data, The Academy of Management
Review 28(3): 371-82. | Eisenhardt, K. (1989) Agency theory: an assessment and review, Academy of Management Review 14: 5774 | Hill, C. W. L., & Jones, T. M. 1992.,
Stakeholder-agency theory. Journal of Management Studies, 29: 131-154. | Hillman, A.J. and Dalziel, T. (2003) Boards of Directors and Firm Performance: Integrating
Agency and Resource Dependence Perspectives, Academy of Management Review 28(3): 383-96. | Jensen, M. and W. Meckling (1976), Theory of the firm: managerial
behaviour, agency costs and ownership structure, Journal of Financial Economics, 3 pp. 305-360. | Jensen, M.C., (1983), Organisation Theory and Methodology the Accounting Review, V.LVIII, 2, pp 319-339. | Maher Maria and Andersson Thomas, Corporate Governance: Effects on Firm Performance and Economic Growth, OECD, 1999.
| Shleifer Hall, Inc. Beaver, W.H. (1989)., A. and Vishny, R. W. (1997), A Survey of Corporate Governance, Journal of Finance 52(2)(June): 737-77.

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