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How Agency Theory Can Explain a Drop in Stock Prices

written by: John Garger•edited by: Laurie Patsalides•updated: 12/27/2010

Conflict between the managers and owners of a corporation erode the value of ownership. Learn why agency theory can help explain why stock prices drop because of a fall in managerial confidence.

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    A principal-agent relationship exists whenever one person acts in the interests of another. Known as agency theory, the costs of not being able to monitor an agent and the divergence of the parties’ goals has real effects on the relationship between an owner of a company and its value. Often, through agreements and contracts, principals are able to reduce the costs of agency by making their goals more in line with the agent’s. However, the relationship between the managers of a corporation and its owners is complex. Owners of a corporation are far removed from its control.

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    The Principle of Self-Interested Behavior

    The principle of self-interested behavior tells us that people, including managers and stockholders, work in their own financial self interest. This is considered the main source of divergence between a manager’s and an owner’s goals. Each wishes to maximize wealth and benefits, often at the expense of the other party. The modern corporation separates ownership and control giving rise to the principal-agent relationship. However, this separation gives managers an opportunity to work in their own self-interest.

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    Prequisites as a Source of Conflict

    One major source of manager-owner goal divergence is found in the perquisites (or perks) a manager enjoys as being a decision-maker in the organization. Perks are those aspects of the company that bring value to a manager but are not a part of the manager’s compensation package. Perks include use of the company jet, expense accounts, company cars, and access to company equipment. Excessively taking advantage of these perks erodes the value of the firm because they represent real costs to stockholders.

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    Shirking Can Cause Conflicts

    Another source of manager-owner conflict is a behavior called shirking. Shirking is not putting forth the best effort to help stockholders realize the largest return possible. Perhaps managers are spending too much time enjoying perks and creating an opportunity cost of not working on projects and day-to-day operations. Whatever the reason, stockholders’ value decreases each time an opportunity for firm improvement is lost to shirking managers.

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    Human Capital and Principal-Agent Conflict

    Another source of manager-owner conflict occurs when managers and employees hold unique skills necessary for business operations. The abilities and skills held by employees are collectively known as human capital. Just like investment capital, it defines what a company is capable of and often creates an important vehicle through which a company may compete in the market. When employees of a firm become specialists over time, their skills become non-diversifiable. We know that diversification is a good thing, but specialty creates what is known as non-diversifiability of human capital, another source of manager-stockholder conflict.

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    Conclusion

    The separation of ownership of a firm and its control allows investors to invest money in multiple companies without having to concentrate on how each firm is actually run. This allows for diversification of assets by the investor to minimize risking all of his/her wealth. However, this separation creates agency problems which erode some of the value of being able to own a company but not having to spend the time to manage it. This value lost is often the result of managers taking too much liberty with perks and of shirking responsibilities. Non-diversifiability of human capital also erodes value when employees become specialists in the firm.