Asymmetric information & Agency problem - UOL Financial Management

Asymmetric information & Agency problem

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Agency theory, a premise often associated with Jensen and Meckling (1976), was first predicated by Alchian and Demsetz (1972) who emphasised that activities of firms were governed by the role of contracts to facilitate voluntary exchange. Agency theory explains how best to organise relationships in which one party (principal) determines the work, which another party (agent) performs. Agency problems are created when the shareholders (principals) hire managers (agents) to make decisions that are in the best interests of the share- holders. These theoretical postulations continue that in general people are self-interested and will therefore have conflicts of interest in any cooperative endeavours (Jensen, 1994).

It naturally follows, then that some decisions of managers are motivated by self-interest, which reduces the welfare of the principal. As both parties can experience losses due to problems of conflict of interest, there is a strong motivation to minimise these agency costs of cooperation. Through monitoring and bonding, the costs of writing and enforcing contracts are minimised. Therefore, agency theory provides a theoretical foundation to understand human organisational arrangements including incentive compensation, auditing and many bonding arrangements.

Where incomplete information and uncertainty exist, agency theory posits that two agency problems follow: adverse selection where the principal cannot determine if the agent is performing the work for which s/he is paid, and moral hazard where the principal is unsure as to whether the agent has performed their work to their ability. Incentives and monitoring mechanisms are proposed as safeguards against opportunism (see, Jensen and Meckling, 1976) in the agent/principal relationship. Opportunistic behaviour is assumed in agency theory, and is perceived as self-interest seeking. Thus, the expectation is that the economic actors may disguise, mislead, distort or cheat as they partner in exchange (Wright and Mukherji, 1999).

According to agency theory, information asymmetry occurs where management (agents) have the competitive advantage of information within the company over that of the owners (principals). This results in the principal’s inability to control the desired action of the agent. Information within an organisation is critical, and management working at the “coal face” of the operations of the company are privy to essential information that can be manipulated to maximise their own interests at the expense of the principal (Godfrey et al., 2003).

As a result of the potential conflict between agent and principal, agents are motivated to contract with owners to minimise the goal incongruence of the two parties. It is argued in agency theory that agents seek monitoring contracts because in the absence of such a contract, owners price protect heavily. Hence, agents engage in bonding activities to reduce the totality of costs imposed on them. The costs incurred in monitoring agency contracts

reduce the manager’s compensation, therefore there is incentive for the agents to minimise these costs by refraining from conflict with the principal (Godfrey et al., 2003; Wolk and Tearney, 1997).

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Arnold & Lange (2003), Enron: an examination of agency problems. Critical Perspectives on Accounting, 15 (2004), pp. 751–765