Module 2 - Agency Theory Separation of Ownership

and Control etc.

By
Dr Manu N Kulkarni,
NITTE School of Management,
MBA class
manu.n.kulkarni@gmail.com
 information
Asymmetric
hires

P A
self
interest

self interest

performs
Basic idea of Agency Theory (P: Principal, A: Agent)
• This theory of Principal – Agent relationship has been
recognized as very important in Corporate Governance issues.

• This is also called Agency Theory and in simple terms, it is all

about Employer Employee relationship.

• In Bureaucracy and in Government parlance it is all about

legislation – bureaucracy relationship.

• As you can see from the Figure, the basic idea of Agency
theory is how the Principal P hires the Agent A and how they
are paid, when they are paid and for what they are paid.
• Both P and A have their own self interest.

• P wants to pay less to the A. And A wants to get more from P.

• P has to motivate the A to get better performance.

• There is also the theory of carrot and stick, There are,

discretionary bonuses, profit sharing, efficiency wages,
differed compensations and so on.

• In Corporate Governance, there is now non financial

compensation. Also called psycho social compensation, pay
for performance method and profit sharing arrangements.
• There are many principles for establishing sound
Principal – Agent relationship.

– A) Informativeness principal
– B) Incentive Intensity principal
– C) Monitoring Intensity principal
– D) Equal Compensation Principal
• The four principles can be summarized in terms of the
simplest (linear) model of incentive compensation:

w = a + b ( e + x + gy)

where,
w wage
e (unobserved) effort
x unobserved exogenous effects on
outcomes
g weight given to y
a base salary
b interpretation of b is as the
intensity of incentives provided to
the employee
• Performance evaluation is linked to the Principal – Agency
relationship.

• Better the performance better the compensation.

• But who will assess the performance of the employee (Agent)?

• It is nice to say Pay for Performance?

• It is here where the Theory of 360 Degree Feedback and

Performance Management System has become important.
(See the book by TV Rao, Raju Rao, Excel Books)
• 360 Degree performance management is nothing but the agent
doing the performance evaluation of the Principal.

• The incentive theory in performance assessment has become

important in Corporate Governance.

• What type of incentives, when to give them and whom to give

them is very important to decide by the CEO of the company.

• Bad incentives to wrong people will send wrong signals to the

employees in an organization.

• Bias theory is very important in understanding Principal –

Agent relationship.
• In State enterprises or Government system, public officials are
the agents and the lobby groups always influence them
through bribes and other types of attractions.

• The important piece of Regulation for Corporate Governance

in India is the SEBI committee report submitted by Kumara
Mangalam Birla in May 1999.

• The most important recommendation of the SEBI Committee

is on definition of independence of the Director. It says that
“material pecuniary relationship which affects independence
of a director” should be the litmus test of independence.