Agency Costs

Abstract

In the traditional analysis of the firm, profit maximization is assumed, subject to the constraints of a technological production function for transforming inputs into output. Optimum production solutions are characterized in terms of the equality between the ratio of marginal products of inputs and the ratio of input prices. While this analysis has provided valuable insights in understanding certain aspects of choices by firms, it completely ignores others having to do with the process through which the inputs are organized and coordinated. In essence, the traditional economic analysis treats the firm as a black box in this transformation of inputs into output. Rarely are questions raised such as: Why are some firms organized as individual proprietorships, some as partnerships, some as corporations, and others as cooperatives or mutuals? Why are some firms financed primarily by equity and others with debt? Why are some inputs owned and others leased? Why do some industries make extensive use of franchising while others do not? Why do some bonds contain call provisions, convertibility provisions, or sinking fund provisions while others do not? Why are some executives compensated with salary while others have extensive stock option or bonus plans? Why do some industries pay workers on a piece-rate basis while others pay at an hourly rate? Why do some firms employ one accounting procedure while others choose alternate procedures? To answer such questions requires the economic analysis of contractual relationships. Agency Theory provides a framework for such an analysis.

This chapter was originally published in The New Palgrave: A Dictionary of Economics, 1st edition, 1987. Edited by John Eatwell, Murray Milgate and Peter Newman