Book Series
Theories of the Firm
Fifth Edition
Demetri Kantarelis

Chapter 8: The principal-agent theory of the firm

197-237The concern of the transaction cost theories discussed in the previous chapter was firms' boundaries. This chapter focuses on the management of relationships between a firm and its various stakeholders (or agents). More specifically, this chapter deals with the firm's concern regarding the management of the conflict of interest between it, the principal, and an agent (or many agents) over a bargain that is subject to costly, unenforceable, contracting. The principal-agent (or agency) theory has shed some light on how to deal with this conflict through, primarily, the engineering of incentive mechanisms. The theory views the firm as a nexus of unenforceable contracts between it and its stakeholders, always in need of 'smarter' schemes to minimise problems associated with opportunism that arise from bounded rationality, holdup, adverse selection, moral hazard, free riding or difficulties monitoring performance and accountability. The problem is how to induce the agent to act in the best interests of the principal when the agent has an informational advantage over, and different interests from, the principal. The theory, assuming that principles and agents are expected utility maximisers with no 'income effects' in their attitudes toward risk, has reached the following broad conclusion:
1 The principal-agent problem
1.1 Private information, opportunism and remedies
1.2 Mechanism design and incentives' engineering
1.2.1 Coordination Mechanism 1: split-the-difference plan
1.2.2 Coordination Mechanism 2: symmetric mediation plan
2 The conflict between the principal and the agent
2.1 Divergence of interests: Model I
2.2 Divergence of interests: Model II
3 Incentive compatibility
4 The profit share (or bonus) incentive
4.1 Risk-sharing between owner and manager
5 The firm without employees
6 The firm with a monitored employee
7 The leisure model
8 Partnership
8.1 Non-opportunistic
8.2 Opportunistic
9 'Team' and the minimisation of free riding
10 A theory of the banking firm
10.1 Loan limits and moral hazard
10.2 Equilibrium
10.3 Heterogeneous clients and adverse selection
10.4 Theory versus reality
10.5 The recent financial crisis
11 Microfinancing
11.1 Microfinancing and adverse selection
11.2 Group-lending and the mitigation of adverse selection problems
11.3 Group-lending and the mitigation of moral hazard
12 Summary
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