- slide 1 of 3
In a principal-agent relationship, each party may seek to fulfill its own self-interest at the expense of the other party. Contracts and agreements help to reduce this self-interested behavior but no expense can ever fully allow a principal to monitor or limit the behavior of the agent. Consequently, conflicts can arise. This relationship is especially true between manages and stockholders of a corporation where the separation of ownership and control allows managers to sometimes act without any monitoring or behavioral limiters.
- slide 2 of 3
Non-diversifiability of human capital occurs when the skills and abilities to run a corporation are tied only to this single firm. Over time, the capabilities needed to manage a firm become specialized and diversification of skills becomes nearly impossible. Like investment capital, human capital can limit or set free a corporation based on the decisions made by managers.
Some companies market products that are unique. Typically, unique products require unique skills; not just anyone can make and manager the products. This has the effect of creating unique skills in employees. Consequently, the employees are so specialized in working for the firm that they are incapable of working for another; they have become such as an integral part of the marketing of the unique product. This results in the owners of the firm having to pay these employees more money than less-specialized employees of other firms because they are needed that much more. The lack of companies for which the specialized employees can work creates a tight bond between the employees and the ability of the firm to operate.
There is a major difference between investment capital and non-diversifiable human capital; they represent costs at different times during the investment cycle. Investment capital costs the company when new investments are made. Human capital costs the company now, during the production of current investments. The time value of money suggests that money today is worth more than money tomorrow. All things being equal, human capital is more expensive that investment capital. This creates conflict between managers and stockholders because growth with new investments is costlier than if the products produced by the company were commodities or common assets. The result is a reduction in stockholder equity because new investments are riskier.
- slide 3 of 3
Asset uniqueness has the effect of making employees highly specialized in marketing a corporation’s product. Specialization leads to non-diversifiable human capital. Because of the timing of investments, investments capital is normally less costly than human capital. Essentially, skills are worth more to the company that markets a unique product than the investment capital needed to start new investments. The conflict that arises dilutes stockholder equity.