Agency theory Essay Example

Jensen and William Meckling shaped the work of Berle and Means in the context of the risk-sharing research popular in the 1960s and 1970s to develop agency theory as a formal concept.

Jensen and Meckling formed a school of thought arguing that corporations are structured to minimize the costs of getting agents to follow the direction and interests of the principals. Agency theory is concerned with resolving problems that can exist in agency relationships; that is, between principals (such as shareholders) and agents of the principals (such as company executives).

There are two problems that agency theory addresses, which are firstly, the problems that arise when the desires or goals of the principal and agent are in conflict, and the principal is unable to verify what the agent is actually doing; and secondly, the problems that arise when the principal and agent have different attitudes towards risk. Because of different risk tolerances, the principal and agent may each be inclined to take different actions. 2. 2 Article 1 From the thesis Agency Theory and Its Consequences, written by Thomas Rudiger Smith.

Through the article “Although the findings cannot be conclusive, certain trends were spotted that gave support to the fact that the application of some agency theory tools may indeed increase risk taking. The negative influence of board size on risk-taking falls directly in line with the proposed agency logic that larger boards are more easily controlled by the manager and therefore less prone to take on risk. Additionally, it was found that the presence of stock based compensation plans, as proposed by agency theory, did indeed help increase the risk profile

of the bank.

However independent boards did make fewer loans, which could hint at the fact that independence does not equate shareholder primacy. The breakdown of knowledge into three measures provided both conflicting and confounding results, as collinearity could not completely be removed. ” “Thereby the REMM is largely similar to the economic model of man, which assumes that humans are rational, selfishly motivated and will behave opportunistically, even ruthlessly, whenever advantageous (Ghoshal 2005, Daily et al. 2003).

Herein, actions are undertaken according to self-interest (Fama 1980) and opportunistic behavior is fostered when monitoring contracts and relationships becomes difficult and costly due to bounded rationality and information asymmetry (Perrow 1986, Donaldson 1990). ” From the article, we can understand humans are rational, selfishly motivated and even ruthlessly, therefore sometimes we always consider ourselves more than someone else, and always hold different opinions in a given problem, which leads to the conflicts with others.

As we know, a corporation is basically has three sets of interest, they are Managers, stockholders and creditors. Stockholders often have conflicts with both banks and managers, since their general priorities are different. Managers want quick profits that increase their own benefit, power and reputation, while shareholders are more interested in slow and steady growth all the time. And the purpose of agency theory is to identify the conflict point among corporate interest groups.

Banks want to reduce risk while shareholders want to maximize profits reasonably. Managers also think about their own interest. The fact that modern corporations are based on these relations creates costs in that each group is trying to control the others. Therefor agency theory

as a theory of corporate governance to help corporate alleviate the problems arising due to the separation of ownership and control.

This discipline was initiated by Cyert and March’s (1963) A Behavioral Theory of the Firm, a work that has becoming one of the cornerstones of industrial economics and finance theory. They view the firm not as an impersonal economic unit in a world of perfect markets and equilibrium but rather as an organization comprising people with differing views and objectives. The theory sees institutions and market as different possible forms of organizing and coordinating economic transactions.

When external transaction costs are higher than the company's internal bureaucratic costs, the company will grow, because the company is able to perform its activities more cheaply, than if the activities were performed in the market. However, if the bureaucratic costs for coordinating the activity are higher than the external transaction costs, the company will be downsized. In 1980s, the theory was further developed by Williamson. Williamson argued that the actions and decisions of managers are based on a combination of bounded rationality and opportunism.

Opportunism has been defined as the active tendency of the human agent to take advantage, of all available means to further his own privileges. The opportunism and bounded rationality will potentially increase the external transaction costs, where it may become rather expensive for a company to control these factors. Therefore, it may very well be more economical to maintain the activity in-house, so that the company will not use resources on any other things, just like contracts with suppliers, meetings, supervision etc.

Therefore, if companies see the nvironmental uncertainty

as high, they might choose to not outsource or exchange resources with the environment. 3. 2 Article 2 In the article: Transactions Cost Theory influence in strategy research: A review through a bibliometric study in leading journals. “Transaction cost theory (TCT), or transaction cost economics (TCE), has become an increasingly important anchor for the analysis of a wide range of strategic and organizational issues of considerable importance to firms (Williamson, 1994; Ghoshal & Moran, 1996; Williamson, 1996; Jones, 1998; Madhok, 2002).

In particular, the TCT has been employed in studying firms’ boundaries, vertical integration decisions, the rationale for conducting an acquisition, the networks and other hybrid governance forms. The TCT has expanded its breath to strategic management and international business in seeking to explain how firms internationalize and the structural arrangements required to improve the odds of success. In fact, it is reasonable to put forward that the TCT has become a pervasive theory in organizational studies. In this article, it analyzes the Transaction Cost Theory’s influence in the academic research in strategic management.

The main research question that transaction cost theory (TCT) seeks to address is why economic transactions are organized in the way that they are in the modern society (Williamson, 1994). The result of this article is that TCT is criticized for failing to explain the alternative forms of organization and many other organizational phenomena. However, TCT does not claim itself as panacea for everything; it only attempts to explain a portion of the organizational phenomena: why and under what conditions transactions are organized in certain ways (Coase, 1937; Williamson, 1979). At best, TCT deals with relative efficiency question.