Question

What is an agency relationship? What is managerial opportunism? What assumptions do owners of corporations make about managers as agents?

(Should be a min of 400 words, properly explained)

NO HANDWRITTEN ANSWERS PLEASE

Answer 1

An Agency relationship is a legal relationship between two parties typically called the “Agent” and the “Principal”. The Principal legally appoints a person or an institution to carry out operations on their behalf. Some examples of a Principal – Agent relationship is the relationship between Politicians and the Voters, Investors – Fund manager relationship, Attorney – Client relationship etc. In general, such relationships are established through clearly written contracts or it is implied by actions. This means that the Agent has the obligation to carry out the operations or act assigned to him by the Principal.

The important aspects of an Agency relationship is “Moral Hazard” and “Conflict of interest”. In Agency relationship, the agent acts of behalf of the principal, which means the agent works for the principal. Moral hazard is a situation in an Agency relationship when the agent does not act in good faith or takes unnecessary risks because he does not bear the consequences of the act. Conflict of interest is a situation in which the agent has other interests which conflict with the principal’s interest. For example, in an Investor – Fund manager relationship, the agent’s interest is to generate better portfolio returns for himself. The agent should act in such a way that maximises the return for the investor. Instead, if the Fund Manager’s interest is to make money for himself, there is a conflict of interest.

Managerial Opportunism is an example of the “Conflict of interest” problem in which the managers act as the Agents. In Managerial Opportunism, the manager or the agent gets the opportunity to act on his self-interest. For example, if a manager’s compensation is proportional to the size of the business he manages, then the manager may push for company expansion even though the expansion may not be profitable for the company.

In general, the agent has more information that the principal because the agent is on the ground performing the actions on behalf of the principal. This is called “asymmetric information”. This information along with the opportunity to misuse the information gives rise to manager opportunism.

Some of the key assumptions owners make when hiring managers as agents are as follows:

1. Managers are capable of performing the actions on behalf of the owners
2. Managers act on the best interest of the owner (i.e) there is no conflict of interest
3. There are enough governance mechanisms that ensures there are not opportunity for the managers to misuse of information – such as the attorney- client confidentiality