SelfInterest and Agency Costs

1
Self-Interest and Agency Costs

• What are agency costs?
• Who pays them?

2
Discussion Question

• On a boat trip up Chinas Yangtze River in the
  19th Century, a titled English woman complained
  to her host of the cruelty to the oarsmen. One
  burly coolie stood over the rowers with a whip,
  making sure there were no laggards.
• Her host explained that the boat was jointly
  owned by the oarsmen, and that they hired the man
  responsible for flogging. (Source Stephen
  Chung)
• Why would such an organizational arrangement
  arise voluntarily?

3
Vocabulary

• Rules of the game
• Preferences
• Transitivity and rationality
• Non-rational behavior
• Perfect agent
• Needs
• Culture

4
Vocabulary

• Evaluation (evaluative)
• Substitution (trade-offs)
• Maximization (Optimization)
• Agency theory (agency costs, moral hazard and
  adverse selection)
• Principal
• Agent
• Organizational structure
• Incentive systems
• Incentive contract

5
Agency Costs

• Conflicts of interest arise in any organization.
• Between owners and managers, between different
  managers, between different owners
• Unresolved agency problems are costly. They
  divert attention and resources away from an
  organizations mission.

6
Agency Costs

• PAM (Pain Avoidance Model) explains the
  non-rational behavior that REMM does not predict
• Non-rational behavior is dysfunctional or
  counterproductive behavior that systematically
  harms the individual
• PAM behaviors are associated with fight or
  flight responses.
• They explain the non-rational behavior and
  internal conflicts of interest that are the
  second source of agency costs.

7
Easing agency problems.

• Conflicts of interest arise between lower and
  upper levels of organizations and across levels.
• Moral hazard
• Adverse selection
• Transfer pricing
• They can be mitigated by writing contracts that
  align interests.
• Contract enforcement also has (high) costs.

8
Easing conflicts

• Other methods are sometimes used to reduce the
  contracting costs and the residual loss from our
  inability to contract on everything or enforce
  perfectly.
• Monitoring (including auditing)
• Bonding

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
Easing agency problems

• All potential solutions are imperfect and
  potentially costly.
• Monitoring costs
• Bonding costs
• Incentive contract costs.
• Residual loss

11
Mom and Pop Illustration
12
Incentive contract costs

• How are incentive contracts costly?
• Transfer risk to managers
• Incentive contracts are difficult to get right.
• How much risk
• How often to pay
• What performance measure
• How to compute the measure
• How to provide feedback
• When to use negative vs. positive rewards

13
What kind of incentive?

• Money is not always the answer
• Working with children or old people
• Working in health care
• Are negative incentives ever necessary?
• Should managers (and others) always get feedback
  before a negative sanction?

14
A firm

• A firm is a nexus of contracts.
• Accounting (financial or non-financial) is
  necessary to define the terms of contracts.
• Performance measures
• Targets
• Links between performance and pay
• Accounting is necessary to enforce the contracts.
  (target vs. actual)
• We do all the measuring

15
Discussion Question

• The practice of tipping waitpersons as a function
  of quality of service in restaurants that the
  customer frequents.

Can you explain the following in terms of agency
problems and REMM behavior?
The practice of tipping waitpersons as a function
of quality of service in restaurants to which the
customer will never return (and in towns in which
the customer doesnt know anyone).
16
Need to know . . .

• What are agency problems?
• What causes them?
• What eases them?
• What are agency costs? Residual losses?
• What are moral hazard and adverse selection?
• What is the role of accounting in solving agency
  problems?
• What are the roles of monitoring and bonding?

17
The end!