Jenson and Meckling (1976) define
agency theory as a relationship between the contractor and another party (the
agent) in which the contractor will delegate some decisions to the agent. In
this relationship, the contractor will hire an agent to perform a specific task
given to them. For instance, in partnerships, the principals are the investors
of an organization, assigning to the specialist i.e. the administration of the
organization, to perform errands for their sake.
Assumptions on Agency theory
There are three assumptions on
agency theory that are related to human behaviour they are humans have bounded
rationality which means that there are breaking points to what individuals
know. The second one is humans are selfish which implies that individuals put
their own needs before other individuals. The final assumption is humans will
always seek to maximise their own utility such as wealth and health over other
Agency costs are costs that are
internal that must be paid to, an agent following up for the benefit of a
principle. After given the assumptions by the agency theory the interests
between the contractor and the agent are divergent, this leads to agency cost
being incurred. These are Monitoring costs by the principal which indicates
whether individuals are performing very well. The second one is Bonding costs
by the agent which indicates whether the individual is reporting back to the
principals to demonstrate performing. The final one is Residual Loss is the
decline in the value of the firm that emerges when the manager reduces his
rights. William (1988) suggest that this is the key cost; however, the other
two are brought are only occurred when they yield financially decreases in the
For example, when an agent
demonstrations reliably with the principals’ interests, agency loss is
nothing. The more an agency pay
attention to the principles interests, the more agency loss increases.
Therefore, the agency should focus more on ideas created by them instead of
taking note from the principle, then agency loss becomes high.
Agency issues arise because of
the disagreement or dissociate of attention between the contractor and the
agent. Agency problem in finance has occurred when there is conflict between
the manager and the shareholders in the business. There are different types of
an agency relationship in finance for instance managers and shareholders.
Managers employ experts (supervisors) who have specialized aptitudes. Managers
may take actions, which are not to the greatest advantage of shareholders. This
is generally when the managers are not the owner of the property i.e. they
don’t have any shareholding. The involvement of the managers will be in
conflict with the interest of the owners. Murphey (1985) argues that managers
tend to build the extent of organisations regardless of whether it hurts the
interests of investors, as regularly their compensation and distinction have
decidedly corresponded with organization measure. Therefore, this causes
conflict between the manager, who tend to esteem development, and investors,
who are orientated towards the boost of the estimation of their offers.
The agency problem in the corporation
According to Smith (1776) the
executives of such like joint stock in organizations, in any case, being the
managers of other individuals’ cash than their own, can’t be very much expected
that they should watch over it with a similar watchfulness with which the
accomplices in a private co-partner as often as possible watch over their own.
The organisation in agency theory
Jenson and Meckling (1976)
suggested that organisations just legitimate fictions which fill in as a nexus
for an arrangement of contracting connections among people.
The role of the board of directors:
Garrat (1997) defines the function
of the board directors as Monitor and control managers and CEO.
Board of directors regularly has
power more than one board. Executives are additionally known to have a few
duties and regularly clashing necessities. They have time requirements, what’s more,
subsequently need to precisely deal with their endeavours for most extreme
outcomes. The main purpose that tests the capability of a board is that of
observing and control of the presidents and their execution. The more
noteworthy the level of observing, the more prominent the likelihood of
achievement or upgraded budgetary execution
In agency theory, there are two
contracts they are outcome-based contracts and behaviourally based contracts.
These are some of the propositions for Outcome-based contracts vs Behavioural
When there is a contract between the principal
and the agent then this is known as outcome-based, the agent will behave most
likely in the interest of the principle.
When the principle has information regarding the
behaviour of the agent, then the agent is most likely to behave in the
interests of the principle.
Information systems are identified positively to
behaviourally based contracts and outcome-based- contracts are identified as
Agency relationship is identified as positively
connected to behaviour-based contracts. Whereas, outcome-based contracts are
identified as negatively connected.
Agency theory and executive compensation
Principal-agent model is the
standard economic theory for executive compensation. The theory supports that
organizations look to plan the most effective compensation packages in order to
attract, retrain, and motivate CEOs, executives, and managers. Shareholders in
the agency model are set to pay. Nevertheless, in practise, the compensation
agency of the board decides to pay for the benefit of shareholders. A principal
who is known as shareholder plans agreement and makes a deal with the agent
(CEO/manager). Executive compensation improves an ethical peril issue such as
manager opportunism emerging from low firm rights. By utilizing investment
opportunities, confined stock, and long-haul contracts, shareholders encourage
the CEO to boost firm esteem. In other words, shareholders will try to plan
optimal compensation bundles to deliver CEO with motivating forces to adjust
their common advantages. This is the agreement way to deal with executive pay.
Resource based view
Barney (1991) define Resourced-
based theory when firms resources and included in all assets, for instance
their abilities, organizational procedures, firm properties, data, information
and so on, these are controlled by a firm in order for the firm to execute
methodologies that enhance its proficiency and adequacy.
All the assets in the firm are heterogeneously
disseminated crosswise over contending firms. Also, all the assets in the firm
are defectively portable which influences this heterogeneity to persevere after
According to Barney (1991) “competitive
advantage in a firm is when it is implementing a value creating strategy not
simultaneously implemented by any current or potential competitor”. An
asset will deliver competitive advantage when it produces an incentive for the
association, and is done in a way that can’t without much of a stretch be
sought after by challengers.
The resourced-based theory of
firms focuses on main two assumptions and they are:
diversity is also known as asset heterogeneity. This resource relates to
whether a firm claims an asset or ability that is likewise owned by various
other contending firms, which means that the asset can’t give a competitive
advantage. For instance, of asset resource diversity, think about the
accompanying: a firm is attempting to choose whether to execute another IT
item. This new item may give a competitive advantage to the firm if no
different contenders have a similar usefulness. In the event that contending
firms have comparative usefulness, at that point, this new IT item doesn’t pass
the ‘asset diversity’ test and for that reason, competitive advantage does not
immobility alludes to an asset that is hard to get by contenders in light
of the fact that the cost of creating, securing or utilizing that asset is too
high. For instance of resource immobility, a firm is endeavouring to choose
whether they should purchase an ‘off-the-rack’ stock control framework or have
one assembled particularly for their necessities. On the off chance that they
purchase an off-the-rack framework, they will have no competitive advantage in
the market over others on the grounds that their opposition can execute a
similar framework. On the off chance that they pay for a modified arrangement
that gives particular usefulness that exclusive they execute, at that point
they will have a competitive advantage, expecting a similar usefulness isn’t
accessible in different items.
Overall, these two assumptions
can be utilized to decide if an association can make a maintainable competitive
advantage by giving a structure or deciding if a procedure or innovation gives
a genuine favourable position over the commercial centre. By using these
assumptions on RBV it shows if sustainable competitive advantage can be
produced and sustained in all firms.
Types of resources:
There are three types of
resources Barney (1991):
capital resources (physical, tangible, technological, plant and equipment)
2. Human capital
resources (training, intangible, experience, insights)
capital resources (formal structure)
VRIN stands for
Valuable, Rare, Inimitable and Non-substitutable. This framework is a tool which
helps organisations analyse their internal resources and capabilities in order
to find out if the resource is a source of sustainable competitive advantage. The
resources must have all the VRIN framework.
VRIN resources of the firm may
enable or limit the choice of markets to be involved, and the levels of profit
to be expected (Wernerfelt, 1989).