Agency theory suggests that the firm can be viewed as a nexus of contracts (loosely defined) between resource holders. An agency relationship arises whenever one or more individuals, called principals, hire one or more other individuals, called agents, to perform some service and then delegate decision-making authority to the agents. The primary agency relationships in business are those (1) between stockholders and managers and (2) between debtholders and stockholders. These relationships are not necessarily harmonious; indeed, agency theory is concerned with so-called agency conflicts, or conflicts of interest between agents and principals. This has implications for, among other things, corporate governance and business ethics. When agency occurs it also tends to give rise to agency costs, which are expenses incurred in order to sustain an effective agency relationship (e.g., offering management performance bonuses to encourage managers to act in the shareholders' interests). Accordingly, agency theory has emerged as a dominant model in the financial economics literature, and is widely discussed in business ethics texts.

Agency theory in a formal sense originated in the early 1970s, but the concepts behind it have a long and varied history. Among the influences are property-rights theories, organization economics, contract law, and political philosophy, including the works of Locke and Hobbes. Some noteworthy scholars involved in agency theory's formative period in the 1970s included Armen Alchian, Harold Demsetz, Michael Jensen, William Meckling, and S.A. Ross.

CONFLICTS BETWEEN MANAGERS AND SHAREHOLDERS

Agency theory raises a fundamental problem in organizations—self-interested behavior. A corporation's managers may have personal goals that compete with the owner's goal of maximization of shareholder wealth. Since the shareholders authorize managers to administer the firm's assets, a potential conflict of interest exists between the two groups.

COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT.

Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather than behave in their own self-interests. The notion of agency costs is perhaps most associated with a seminal 1976 Journal of Finance paper by Michael Jensen and William Meckling, who suggested that corporate debt levels and management equity levels are both influenced by a wish to contain agency costs. There are three major types of agency costs: (1) expenditures to monitor managerial activities, such as audit costs; (2) expenditures to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside members to the board of directors or restructuring the company's business units and management hierarchy; and (3) opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for shareholder votes on specific issues, limit the ability of managers to take actions that advance shareholder wealth.

In the absence of efforts by shareholders to alter managerial behavior, there will typically be some loss of shareholder wealth due to inappropriate managerial actions. On the other hand, agency costs would be excessive if shareholders attempted to ensure that every managerial action conformed with shareholder interests. Therefore,

the optimal amount of agency costs to be borne by shareholders is determined in a cost-benefit context—agency costs should be increased as long as each incremental dollar spent results in at least a dollar increase in shareholder wealth.

MECHANISMS FOR DEALING WITH SHAREHOLDER-MANAGER CONFLICTS

There are two polar positions for dealing with shareholder-manager agency conflicts. At one extreme, the firm's managers are compensated entirely on the basis of stock price changes. In this case, agency costs will be low because managers have great incentives to maximize shareholder wealth. It would be extremely difficult, however, to hire talented managers under these contractual terms because the firm's earnings would be affected by economic events that are not under managerial control. At the other extreme, stockholders could monitor every managerial action, but this would be extremely costly and inefficient. The optimal solution lies between the extremes, where executive compensation is tied to performance, but some monitoring is also undertaken. In addition to monitoring, the following mechanisms encourage managers to act in shareholders' interests: (1) performance-based incentive plans, (2) direct intervention by shareholders, (3) the threat of firing, and (4) the threat of takeover.

Most publicly traded firms now employ performance shares, which are shares of stock given to executives on the basis of performances as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes. If corporate performance is above the performance targets, the firm's managers earn more shares. If performance is below the target, however, they receive less than 100 percent of the shares. Incentive-based compensation plans, such as performance shares, are designed to satisfy two objectives. First, they offer executives incentives to take actions that will enhance shareholder wealth. Second, these plans help companies attract and retain managers who have the confidence to risk their financial future on their own abilities—which should lead to better performance.

An increasing percentage of common stock in corporate America is owned by institutional investors such as insurance companies, pension funds, and mutual funds. The institutional money managers have the clout, if they choose, to exert considerable influence over a firm's operations. Institutional investors can influence a firm's managers in two primary ways. First, they can meet with a firm's management and offer suggestions regarding the firm's operations. Second, institutional shareholders can sponsor a proposal to be voted on at the annual stockholders' meeting, even if the proposal is opposed by management. Although such shareholder-sponsored proposals are nonbinding and involve issues outside day-to-day operations, the results of these votes clearly influence management opinion.

In the past, the likelihood of a large company's management being ousted by its stockholders was so remote that it posed little threat. This was true because the ownership of most firms was so widely distributed, and management's control over the voting mechanism so strong, that it was almost impossible for dissident stockholders to obtain the necessary votes required to remove the managers. In recent years, however, the chief executive officers at American Express Co., General Motors Corp., IBM, and Kmart have all resigned in the midst of institutional opposition and speculation that their departures were associated with their companies' poor operating

Stakeholder theory has been articulated in a number of ways, but

in each of these ways stakeholders represent a broader

constituency for corporate responsibility than stockholders.

Discussions of stakeholder theory invariably present contrasting

views of whether a corporation's responsibility is primarily (or only)

to deliver profits to the stockholders/owners. Milton Friedman's

(1912-) now-famous pronouncement that the only social

responsibility of corporations is to provide a profit for its owners

stands in direct contrast to those who claim that a corporation's

responsibilities extend to non-stockholder interests as well.

One very broad definition of a stakeholder is any group or

individual which can affect or is affected by an organization." Such

a broad conception would include suppliers, customers,

stockholders, employees, the media, political action groups,

communities, and governments. A more narrow view of stakeholder

would include employees, suppliers, customers, financial

institutions, and local communities where the corporation does its

business. But in either case, the claims on corporate conscience are

considerably greater than the imperatives of maximizing financial

return to stockholders.

Stakeholder theories have grown in number and type since the

term stakeholder was first coined in 1963. According to R. Edward

Freeman, whose work in stakeholder theory is well known, the

stakeholder concept was originally defined as including "those

groups without whose support the organization would cease to

exist." As a part of management theory and practice, stakeholder

theory takes a number of forms. Descriptively, some research on

stakeholder theory assumes that managers who wish to maximize

their firm's potential will take broader stakeholder interests into

account. This gives rise to a number of studies on how managers,

firms, and stakeholders do in fact interact. Normatively, other

management studies and theories will discuss how corporations

ought to interact with various stakeholders.