Lecture 17: Agency Costs
• Employees or contractors not behaving as
they should — is a part of what we call
Agency Costs or Agency Problems.
• Agency costs are a problem whenever a
principal hires an agent to act on his
behalf. Boss hires a worker.
• Solving this universal problems is a key
managerial problem in managing
personnel and in controlling costs.
Drawback of Firms: Agency Costs
Agency costs arises from separation of ownership and
control.
Owners of firms are interested in profit maximization.
Managers, employees, and suppliers are interested in
maximizing their own self-interests.
How do we give employees incentives to act as if they
were owners of the firm?
How do we get employees to not shirk—that is, work as
hard as they can in the manner the owners would
want? It is a matter of incentives.
Agency Costs . . .
• These are a problem because we are human.
If we “cheat” ourselves, then no one else
bears the cost. So the one-person firm does
not suffer agency costs.
• It is natural for us to want to exploit others: get
others to pay more than they agreed to pay or
we produce less than we agreed to produce. A
divergence in interest between principal and
agent in a multi-person organization and in
contracts.
Monitoring
We have incentives to shirk – take more than
we should or work less than we should.
Monitoring is costly, so sensible to accept
some losses. Many forms of monitoring
exist (spot checks, etc.).
Usually there is unequal (asymmetric)
information between parties. One knows
more than the other and can exploit that.
Examples: Person selling used car (seller exploits
buyer)
Buying insurance (buyer exploits seller)
Monitoring, Bonding & Signals
• How do we assure customers that we can
be trusted, so they should deal with us?
Various devices:
Fixed price contracts; Bonds; Warranties;
Take payment as % later (Accenture)
Less formal: Reputation. This matters
greatly in the market. Diamond market in
New York—close family, social and
religious ties impose special discipline.
Entrepreneurs and their Firms
• Key Managerial Problem:
Giving employees incentives to act as if
they are owners.
The entrepreneur or top manager must
cede authority to others. The issue is:
How do we structure an organization to
reduce agency costs? The movement
has been in this direction; especially in
knowledge-based production.
Decentralization: Pros & Cons
• Empowering workers and managers.
BENEFITS:
1. More effective use of local knowledge —
those closest know the most
2. Conservation of senior management —
top people cannot know or do everything
3. Training & motivation for local managers:
helps attract and keep good managers
and train future top managers
Decentralization . . .
Empowering workers and managers:
COSTS:
1. Agency costs—
shirking; self-dealing — so control and
monitoring measures needed
2. Coordination costs and failures —
duplication; pricing errors
3. Less effective use of central information—
local managers cannot know all information the
central managers have, so have inferior knowledge
Team Production:
Increasing or Decreasing Costs?
Create teams of people with different expertise to make
decisions—
Ex.—Hallmark Cards had teams of art, design, production
and marketing assigned by holiday with decision rights
rather than move produce from functional area to area—
cut time in half.
Benefits—Improved use of specific knowledge and employee
“buy in” due to better information, more cooperation & less
blame.
Costs—Collective-action and free-rider problems.
Same thing in car production—team development tried at
Chrysler; separate functional areas at GM. Tradeoffs.
Decision Management & Control
Agents (managers within a firm) do not
bear the full cost of their actions, so
cannot be delegated both decision
management and control — hierarchy
still necessary.
Make authority and lines of control clear.
Clear communications — top down and
down up — are critical.
Getting Workers to Monitor Each Other
• Nucor has been one of the few successful steel
makers in the U.S. It keeps management small
and adapts new technology quickly.
• Production workers are in teams. Base salaries
are below industry standards. Teams are given
production goals. Beating goals allows salary to be
more than doubled. Penalties for mistakes are
severe, so quality maintained. If one worker shirks
then everyone suffers.
• Who is likely to want to work at Nucor?
Questions: How Do We Overcome
Agency Costs?
• The larger the organization, or the greater the
distance from the owners to the workers, the
more likely that agency costs will become
significant —large corporation look more like an
inefficient government agency.
What economic incentives do firms take to try to
give workers proper incentives?
What about ESOPs? Compensation schemes?
Why Pay Workers More the More Years
They Work?
• Wages tend to rise
with job tenure. Is it Wages
because older workers
are more productive
than younger
workers?
Pay
Productivity
Job Tenure
Why “backload” wages?
• Give younger workers incentive to work hard
and get the rewards later—and know that
loyalty is rewarded.
• This reduces incentives to shirk. If you
perform well, you will be taken care of later.
• One study in Germany showed that workers
with 5 years more tenure, but identical work
skills, got 25% greater wages than younger
workers.
Does the Boss Deserve His/Her Pay?
Many complaints about “excessive” compensation
of CEOs.
How much is it and how much is too much?
Some athletes make $100 million a year—is that
too much? Why is there resentment about CEOs
who make $100 million per year?
What if the CEO founded the company? Does that
make a difference?
Agency Problems at the Top
CEOs capture about 8% of the accounting profit of
public firms. Is that too much?
Studies show that CEO compensation is higher the
less monitoring there is:
When boards are weak or ineffectual (loaded with
friends of CEO).
When there is no large outside shareholder.
When there are fewer large institutional investors.
When there is an anti-takeover arrangement.
Evidence of Weak Monitoring
If high compensation is deserved—why hide it?
Some compensation non-transparent:
Back dated stock options;
Below market rate large loans (that may be forgiven);
Generous pensions not related to performance;
Generous in-kind benefits (company planes) not related to
performance;
Consulting contracts upon retirement or being forced out;
Large bonus upon retirement, or even when forced out, that
was not part of the compensation package;
Use of compensation consultants who have every incentive
to make the CEO happy.
Corporations Have Problems
In sum, the corporate form of organization is
not perfect.
The alternatives—non-profits and government
bureaus—have far worse performance
problems.
Much of modern wealth is tied to the rise of the
modern business organizations—getting
incentives right.
Question: Large Organization with
Simple Monitoring
• Mary Kay Cosmetics grew from sale of
$200,000 in 1963 to over $600 million in
1993, 30 years later. The product is
common and very competitive. The key to
growth was measurement of employee
effort and rewards.
• What was it?
Are Incentives Right?
Dealers at casinos in Las Vegas earn about
$100,000 per year—almost all on tips.
Their wages are about $12,000.
Casino owner Steve Wynn ordered tip
money pooled and shared with managers.
Why?
Question on Team Incentives
• Suppose different numbers of people are
assigned to pull a rope “as hard as you can.”
• One person pulls the rope.
• Three people pull the rope together.
• Eight people pull the rope together.
• How does the pulling force (work effort) per
person change across these three cases?
Incentives of Managers
In the fast-food industry, 30% of stores are company
owned and run by a salaried manager. 70% of the
stores are run as franchises by owner-operators
who split profits with the parent company.
1) Which kind of store would you think would tend
to be more profitable?
2) Why then does the parent choose to own
some? Where would they be located?
3) Would you expect employees to see a
difference in the managers?