Agency Theory

Agency theory entered economic thought in its official form in the early seventies of the last century at the hands of researchers (Jensen and Meckling), but the concepts on which this theory is based go back to the well-known economist Adam Smith when he discussed the problem of separation between ownership and control (management) in his book “The Wealth of Nations” in 1776, where he said:

“The directors of joint-stock companies being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own, Negligence and profusion, therefore,must always prevail, more or less, in the management of the affairs of such a company.”

Adam Smith mourned with great sadness the state of joint-stock companies in his time, saying about their managers, “Because they manage people’s money and not their own, negligence and extravagance must prevail to some degree in the management of the affairs of these companies.”

Jensen and Meckling describe an agency relationship as “a contract whereby one or more individuals (the principal) appoint one or more individuals (the agent) to perform certain acts or services on his behalf, and in return the principal authorizes the agent to make certain decisions.”

Jensen and Meckling also considered the company to be a chain (node) of contracts between different parties.

The agency theory was divided into two theories: the first is normative, which considered that the relationship is between the owner and the manager only, and that the manager is inactive but only implements the owner’s requests.

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The second theory is the positive theory, which considered that the relationship is between all parties related to the company and that the manager is an active person, and since he is not an owner, he is concerned with achieving his personal interests before the interests of the company.

The emergence of the agency theory and what is related to it (the agency problem) has led to increased interest and thinking about the necessity of having a set of laws and regulations that work to protect the interests of shareholders (the principal) and limit the financial and administrative manipulation that may be carried out by members of the board of directors (the agent) with the aim of maximizing their own interests.

The agency theory assumes that the goals and preferences of the principal and the agent differ, which leads to the emergence of the agency problem due to the principal’s inability to monitor the agent’s performance, in addition to the asymmetry of information, as the management (the agent) has more information than the principal (the owners), and even if the same information is available to the principal, he may not be able to interpret it with the same ability as the specialized agent.

To solve the agency problem arising from the conflict of interest between owners and management, the following was proposed:
-Giving management their compensation in the form of shares.
-Monitoring every action of management closely, which is very expensive and ineffective.
-The best way to address the problem lies in between the previous two solutions by linking management compensation to performance with some direct supervision.

In addition to explaining the agency problem, this theory also explains the costs resulting from conflicts between owners and management, which are:
-Control cost: borne by the principal (includes all costs incurred by the process of controlling the agent).
-Trust cost: borne by the agent (who exerts his effort to confirm that he is a trustworthy person and able to fulfill his promise).
-Residual loss cost: borne by the principal (which represents the difference between the cost of the decision taken by the manager and the cost of the decision that he would have taken if he were an owner).

This is what drives the conflicting parties to agree to reduce these costs in order to achieve the goals of the institution as a whole and not to achieve the goal of one party at the expense of the other parties. This can be done through what is called the rules of good management or governance.

Reference

1. Jensen,M and Meckling,W, Theory of the firm: Managerial behavior, Ageny Costs and Ownership Structure. Journal of financial economics,3 Oct 1976.
2. محمد مصطفى سليمان، حوكمة الشركات ومعالجة الفساد المالي والإداري، الدار الجامعية، الإسكندرية، جمهورية مصر العربية، الطبعة الأولى، 2006.
3. حسين القاضي، كنان ندَّه، مبادئ حوكمة الشركات في سوريا (دراسة مقارنة مع مصر والأردن)، مجلة جامعة دمشق للعلوم الاقتصادية والقانونية، المجلد26، العدد الثاني، 2010.
4. حبار عبد الرزاق، الالتزام بمتطلبات لجنة بازل كمدخل لإرساء الحوكمة في القطاع المصرفي العربي-حالة دول شمال إفريقيا، مجلة اقتصاديات شمال إفريقيا، العدد7، 2009.
5. فلاق صليحة، دور آليات الحوكمة في تفعيل أداء شركات التأمين التكافلي، الأكاديمية للدراسات الاجتماعية والإنسانية، قسم العلوم الاقتصادية والقانونية، العدد11، 2014.
6. طارق عبد العال حماد، حوكمة الشركات (المفاهيم-المبادئ-التجارب)، الدار الجامعية – الإسكندرية، جمهورية مصر العربية، 2005.
7. المعتصم بالله الغرياني، حوكمة الشركات المساهمة-دراسة في الأسس الاقتصادية والقانونية، الدار الجامعية – مصر، 2008.

The following video from the Business Tutorials YouTube channel gives an overview of the agency relationship:

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