Self-Interest and Agency Costs

1
Self-Interest and Agency Costs

• The Link Between Agency Problems, Agency Costs,
  and Accounting

2
Principal-Agent RelationshipAccy 201/202

• When two parties enter into explicit or implicit
  agreements whereby one party agrees to perform a
  task or supply a good for the other.
• The party that contracts to have a service or
  good provided is considered the principal
• The party that supplies the good or service is
  considered the agent

3
The Nature of Agency Problems

• Behavioral researchers have found that
  individuals within an organization have their own
  goals, which may not be (and probably are not)
  the same as those of the organization.
• This conflict of behaviors and goals is called
  the Agency problem (Principal-Agent problem).
• The key for the organization is to motivate
  individuals to behave as if they did have the
  same goals.

4
Types of Agency Problems

• Between PeopleOwners v. managers, between
  different managers (e.g., divisions), between
  different owners (e.g., minority shareholders)
• Self Conflict Pain Avoidance ModelIn avoiding
  pain of personal error, may incur more pain
  (yelling at someone else when you know you are
  wrong)

5
Information asymmetry

• When there are differences in the information
  known between the principal and the agent,
  information asymmetry problems can occur.

6
Information Asymmetry Problems

• Adverse Selection, in which one of the
  contracting parties knows information that the
  other party does not, and benefits by not
  communicating that information before signing the
  contract
• Moral Hazard, where the party that knows
  information does not communicate it after the
  contract is signed

7
Discussion Question

• A small community pre-natal health clinic was
  established with funds collected by the local tax
  authority. The clinics mission is to provide
  professional prenatal health care supervision to
  local citizens in need of such services. Health
  care professionals at the clinic volunteer their
  time. Their performance at the clinic is
  evaluated on the number of mothers-to-be they
  treat.

8
Agency costs

• As a result of the agency problems, agency costs
  are incurred
• Agency Costs are the costs of agents pursuing
  their own interests instead of the principals.
  Costs include the reduction of the value of the
  firm and all resources expended to reduce the
  divergence of interest

9
Easing agency problems

• Conflicts between managers and owners can be
  mitigated by well-thought-out incentive
  contracts.
• Conflicts between companies and potential
  creditors or other providers of capital can be
  mitigated by reliable financial statement audits
  (a form of monitoring).
• Task level conflicts of interest can often be
  solved by monitoring, piece work pay plans, or
  other control schemes that subject employees to
  little or no risk

10
Any more guidance on easing agency problems..

• Sure,
• we will discuss the rules of the game during
  next class
• But before we go let us discuss the following
  question

11
Discussion Question
Explain the practice of tipping restaurant wait
staff as a function of quality of service in
terms of agency problems and REMM behavior in

• restaurants that the customer frequents
• restaurants to which the customer will never
  return (and in towns which the customer doesnt
  know anyone