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Chapter 7 Agency Theory.docx

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Ryerson University
FIN 800
Lorne Zeiler

FIN800 Ethics in Finance CHAPTER 7 Agency Theory  Agency theory: application of game theory to the analysis of a particular social interaction, namely “situations in which one individual (the agent) acts on behalf of another (the principal) and is supposed to advance principal’s goals” o Theory of the firm is a natural extension of economic theory from an analysis of markets to an analysis of internal structure of corporations, in order to bridge the gap between utility-maximization hypothesis and profit- maximization assumption CONFLICT WITH BUSINESS ETHICS  Principal-agent theory is about how individuals manage situations involving “goal incongruity” between two or more persons  To clarify the issues of agency theory o Important to get clear on sort of theoretical commitments that are essential to agency theory, in order to distinguish between agency theory itself and certain incorrect interpretations that have become widely promulgated o Important to be more specific about different ways agency theory can be used to analyze relations within the firm, in order to determine whether it is the use or the abuse of agency theory that has become a source of mischief o Important to be more specific about circumstances in which moral obligations can arise out of agency relations AGENCY THEORY AND SELF-INTEREST  Assume that conflicts of interest that give rise to agency-risks may result from a variety of motivations, on the part of agents and principals  Even if theoretical framework does not force them to do so, agency theorists make unflattering empirical assumptions about individual preferences, by stipulating in their models that, for example, work effort has negative utility, money rewards have positive utility, and individuals have no other relevant motivations  Two outstanding problems: 1. The first of two outstanding problems stems directly from the tendency among game theorists to black-box all questions of motivation  Theoretical strategy does allow them to sidestep disputes over altruism and egoism, it also leaves them without a developed theory of preference formation, and thus without an ability to model the way that preference changes arise out of social interactions  There is nothing intrinsic to agency theory that prevents people from taking interest in the way that internal incentives such as preference change can be used to overcome agency problems; it is just that game theorists have no idea how to model such processes, and so chose to ignore them 2. The second outstanding problem involves commitment on the part of the agency theorist to the view that individuals will behave opportunistically whenever given the chance to do so  Two components of opportunism n the standard sense of the term o Taking advantage of circumstances as they arise o Acting without regard for principle  Opportunistic behaviour: direct consequence of agents acting in accordance with the general game theoretic principle known as sequential rationality  Consequentialism postulate: value of an action is a function of its anticipated consequences, and nothing else (commitment to reoptimization follows almost immediately from this consequentialism) o Possibility that rational agent might incorporate deontic constraints – principles associated directly with actions, independent of their consequences – into his deliberation AGENCY THEORY AND SHAREHOLDER PRIMACY  Pure agency relationship: relationship between stockholders and the managers of a corporation o Positive claim about the structure of the firm, not a normative claim about how the firm should be organized o Creates ambiguity concerning who is the agent and who is the principal  Incentive theory: principle is the individual whose welfare is to be served and this welfare is affected by an agent who makes decisions on behalf of the principal o Principle is the one whose welfare ought to be served; agent is the one who is under an obligation to serve the principal faithfully FIN800 Ethics in Finance  Normative stakeholder theory would regard to say that manager is suppose to advance interests of shareholders,
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