© 2006 Pearson Education Canada Inc.9-1 Conflict Resolution Game Theory Agency Theory.

© 2006 Pearson Education Canada Inc.

9-1

Conflict Resolution

Game TheoryAgency Theory


9-2

Agency Theory

• A principal wants to hire an agent for some specialized task– Separation of ownership and control

• Principal and agent are rational. Agent is risk-averse. Principal may be risk-averse, but assume risk-neutral for simplicity

• Principal wants agent to work hard, but– Agent is effort-averse


9-3

Moral Hazard Problem of Information

Asymmetry • Principal cannot observe manager

effort - \• Call manager’s disutility of effort

V(a)– More effort---> greater disutility

• Implies manager may shirk on effort– E.g., if paid a fixed salary, how hard will

the manager work?


9-4

Agency Contract Example 9.3

• Owner: rational, risk-neutral– Wants to max. expected firm

payoff x• Manager: rational, risk-averse

and effort-averse– Wants to max. expected utility of

compensation c, net of disutility of effort V(a)

– To overcome shirking, why not give manager a share of payoff?


9-5

Agency Contract Example 9.3

• A problem arises:– Firm payoff not known until after

contract expires (single period contract). Why?

– Manager has to be paid at contract expiry

• A solution:– Base manager compensation on a

performance measure (e.g., net income), which is available at period end


9-6

Motivation of Manager Effort

• To motivate manager effort, give manager a share of firm net income

• Concept of reservation utility, call it R– If manager is to work for owner, must

receive expected utility of at least R


9-7

Implications of Agency Theory For Financial

Accounting• Net income matters• The agency relationship is a

contract. Contracts are rigid• Implies accounting policy choice

and changes to accounting policy matter

•Manager will usually object to new accounting standards that:

– Lower reported net income (why?)– Increase its volatility (why?)


9-8

Implications, Cont’d.

• Net income must be jointly observable (i.e., by manager and owner)– Role for GAAP, audit


9-9

Implications, Concl.

• Unfortunately, sensitivity and precision must be traded off– Historical cost accounting

• Low sensitivity due to recognition lag• High precision since relatively unaffected by market-

wide factors– Fair value accounting

• High sensitivity due less recognition lag• Low precision since affected by market-wide factors

• Fundamental problem of financial accounting theory– Most useful net income for investors is not

necessarily the most informative about manager effort

© 2006 Pearson Education Canada Inc.9-1 Conflict Resolution Game Theory Agency Theory.

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Transcript of © 2006 Pearson Education Canada Inc.9-1 Conflict Resolution Game Theory Agency Theory.