Summary of Agency theory

The key research question for agency theory is: how to develop efficient contract to provide agents with enough incentives and at the same time maximizing the gain of the principles.

Classic agency theory:

The classic Agency theory
The procedure of classic agency theory:
1. the principle and agency sign a compensation contract
2. The agent chooses an action, but the principle cannot observe the choice
3. Events beyond the agent's control occur
4. The agenct's outcome is influenced by action and noice term
5. The agents receive the compensation from the principle

The assumption is that agency is risk averse. Therefore, the principles cannot give sell the company to the agents, because the agents will feel unsecure and do nothing with the company. On the other hand, the principles cannot only provide fixed income to the agents, because the agents will not have any incentives to work hard.

The solution to design a lineary contract, where the fixed part provide insurance and the flexible part depends on the performance of the agents. The linear solution is critisized because Mirrlees (1974) shows that nonlinear contract, such as step-function contract can be superior to linear contract. Holmstrom and Milgrom (1999) show that the contract should be viewed across different periods. Each period, the wage should depend on the outcome at the end of that period.Therefore, step-function is just one form of linear function of contract.

The basic assumptions are opportunism, and information asymmetry.

Empirical example: The unrestricted nature of the common stock residual claims of open corporations leads to an important agency problem (Jensen and Fama, 1983). The decision process is in the hands of professional managers whose interests are not identical to those of residual claimants. This problem of separation of "ownership" and "control"--more precisely, the separation of residual risk bearing from decision functions. Therefore, agency costs include the costs of structuring, monitoring, and bonding a set of contracts among agents with conflicting interests, plus the residual loss incurred because the cost of full enforcement of contracts exceeds the benefits.

New foundations for the theory of incentive contracts
In 1975, Steven Kerr found that traditional incentive contract cannot solve the problem that some companies met. For example, In 1992, Sears abolished the commission plan in its auto-repair shops, which paid mechanics based on the profit gained from the consumers. The California officials prepared to close Sears' auto repair business statewide, as a lot of consumers complain that mechanics misled them to pay more than they needed.

The problem is caused by the idea that principles need to take other things into account rather than just profits. Therefore, now the agents try to maximize contributions, but principles try to maximize profits. The contract should be designed in a way that do not let agents focus more on the parts that are not related to profits.

Object performance measure
One way is to use linear function based on contribution - multitask model. However, problem is that agents will distort the incentives and focusing on the part that does not related to profits. The distortion depends on the ratio between contribution and profits and how much contribution and profits align with each other (Holmstrom and Milgrom, 1999).

Relational contract (subject performance measure)
Another way is to make contract that is based on repeated games. The principle make promise to the agents that they will pay on the basis of their certain performance, however, the effectiveness of the contract is influenced by the credibility of the principle (Baker et al. , 1994).

New direction in Incentive theory

Previous literature assumes that incentives comes only from monetary rewards, which is not true in reality. People also care about their career and capabilities.

Career concerns: incentives without contracts
Managers typically work too hard in early years to show their capability and not hard enough in the late years.The career concerns is an incentive for efforts.

Investing in capabilities: paying for future performance

The capability concern is an incentive to invest. The promise to promoting is different from previous contract in that it depends on principles' decisions not on agents' outcomes. Therefore, it provides agents with the incentive to invest in their human capital.

New Applications to Supply transactions
 
This part links TCE with agency theory. Scholars derive two optimal incentive contract with integration and without integration. By comparing the social welfare of these two contracts, the decision of integration can be made.
By investigating the contract between and within firms, scholars find that besides incentive design, other decisions of the firms, such as product design, asset investment and job design, etc. all need to be considered in the integration decisions.
Relational contract between firms are threatened by asset ownership. Those firms that own the assets have temptation to renege on the relational contract.



Critics:
1) by stewardship theory: Stewardship theory rejects the agency theory assumptions and presupposes context in which managers perceive that satisfying shareholders goals is also in their personal interest. Separation of ownership and corporate control does not automatically lead to the conflict of goals and interests between owners and managers. 

2) Undersocialized. Donaldson (1997) criticized the agency theory dominance in terms of methodology individualism, narrow-defined motivation model, regressive simplification, disregarding other research, ideological framework, organizational economics and corporate governance's defensiveness.

References:

Mirrlees, J. (1974). Notes on welfare economics, information and uncertainty. Essays on economic behavior under uncertainty, 243-261.

Holmstrom, B., & Milgrom, P. (1991). Multitask principal-agent analyses: Incentive contracts, asset ownership, and job design. Journal of Law, Economics, & Organization, 24-52.

Fama, E. F., & Jensen, M. C. (1983). Separation of ownership and control. Journal of law and economics, 301-325.

Kerr, S. (1975). On the folly of rewarding A, while hoping for B. Academy of Management journal, 18(4), 769-783.

Baker, G., Gibbons, R., & Murphy, K. J. (1993). Subjective performance measures in optimal incentive contracts (No. w4480). National Bureau of Economic Research.

Davis, J. H., Schoorman, F. D., & Donaldson, L. (1997). Toward a stewardship theory of management. Academy of Management review, 22(1), 20-47.