An agency relationship occurs whenever one person delegates decision-making authority to another. The principal is the person delegating authority, and the agent is the person to whom the authority is delegated.
The agency problem is that principals and agents may have different goals, and therefore, that agents may act in ways that are not in the best interests of their principals.
Boards of directors typically make executive pay decisions, in order to control expenses. However, CEOs can use their influence with the board to get pay increases. The historically high level of CEO pay in the U.S. can be attributed to this cause.
The Challenge for Principals
The agency problem also exists in the relationship between higher-level managers and their lower-level subordinates. For example, a subordinate may withhold information to increase his pay or job security or get more than his unit's fair share of organizational resources.
Governance mechanisms are put in place by principals to align agents' incentives with their own, and to monitor and control agents.
I. Stockholders and senior management.
II: An agency relation is established whenever top management delegates authority to lower levels of management.
A. lobbying/political costs
A. A manager accepts a project with a negative net present value.
Linking the manager's compensation to stock performance aligns the manager's interest with that of shareholders, and reduces conflict.
A. Agency costs include managerial perquisite consumption.