Agency Costs:
Incentives Matter
15
“If you would persuade,
appeal to interest and
not to reason.”
Benjamin Franklin
Poor Richard’s Almanack
1732-1758
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.
• Solving this universal problems is a key
managerial problem in managing personnel
and in controlling costs.
Why can’t people be this nice?
Drawback of Firms: Agency Costs
Agency costs arises from separation of ownership & 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.
Basic Human Nature
• This is what most people want to do when
they are supposed
to be working:
• This is what we want
employees to be doing:
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 (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.
Managers and their Firms
• Key Managerial Problem:
Giving employees incentives to act as if
they are owners.
The entrepreneur or 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 knowledgebased production.
Dealing with Agency Costs
Common solution: “Cost centers” within firms.
Hold each part of the organization accountable.
Problems: 1. How do you count overhead costs?
2. Accounting costs ignore some economic costs.
3. Parts of firm impose “tax” on other parts of firm,
charging prices too high.
4. Organization become tied to internal suppliers
(each part forced to buy from other inside parts—
internal capital markets), internal suppliers
protected from competition. Firm loses the benefit
of market knowledge about costs and technology.
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 expertises to make decisions—
Example—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.
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?
• And: Greater ability to protect workers in recession.
Simple Rules May Not Work So Well
3M is an innovative company with 50,000 products,
but most income is from a few products.
Company had a rule that 30% of each division’s sales
must be from new products every 4 years. Forced
innovation. Company was performing below
average.
New CEO studied the innovations. Many were trivial—
change the color of a product and call it new.
Scrapped the 30% rule; focus on best products and
on small number of innovations that look promising.
Some Traditional Systems (Piece Rate)
Can Work Well
Safelite Glass is largest installer of windshields on
cars in U.S. (windshield replacement).
Workers were paid hourly wage rate—drive to
customer location and install windshield.
Average was 2.7 windshields per day.
Company changed to piece-rate compensation—
low base salary plus bonus for each windshield
installed. Productivity increased 20% (3.24
windshield per day per worker). Workers were
happier & less turnover of good workers.
It Happens High Level and Low
In 2005, the Merrill Lynch board approved new
incentive program for CEO and senior managers:
raise return on equity in the next 3 years and you
get rich. Given that incentive, what happened?
1. Merrill repurchased $9 billion of its existing stock
to increase return to remaining stock.
2. Firm went more heavily in high-risk assets such
as sub-prime mortgages (high risk = high return).
Result: 2006 great! Short term thinking, not long.
What happened in the crash in 2008?
Other incentives…
• Not everyone can have stock options. Cash
bonuses work well at lower levels—a goal to
strive for—getting a nice big payoff.
• BUT—people respond to incentives so watch
how rewards structured.
• Why the sub-prime mortgage mess? Banks paid
lenders based on quantity of mortgages made,
not quality. If pay for quantity, better have a
quality measure in place too—charge back for
failures (rather like car dealership repairmen).
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?
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.