The Agency Problem

Topics: Principal-agent problem, Economics, Governance Pages: 7 (2105 words) Published: January 11, 2012
The Effectiveness of Pro-market Reforms, Ownership Structure and The Institutional framework at Addressing the Agency Problem and how Different Types of Firms in Transition Economies are affected by these measures.

As economies grow, in order for businesses to retain market shares, they can no longer rely on organic growth, many seek external finance either through initial public offerings or through banks, mutual funds and insurance companies. Although there are many side benefits of pursuing such growth strategy like dispersion of the entrepreneurs’ financial risk and gains from the specialised human capital of managers, there remains a significant problem: the principle-agent problem. While this problem is largely believed to be a phenomena belonging to transition economies, it concerns all economies as it directly affects access to capital hence the performance of businesses. The UK, US, Germany and Japan demonstrate some of the best corporate governance in the world however, whilst the US restrict large shareholders, Japan and Germany rely on large ownership by banks to curb managers’ opportunism. Despite the on-going discussion, both approaches are regarded as efficient and the overarching factor that gives them success is their effective legal system – institutional framework. Therefore, in my essay, I will firstly discuss the cause of the agency problem, then assess the different approaches to eliminate this problem namely, pro-market reforms and ownership structures but I argue that both of these factors rely primarily on the institutional framework to enforce regulations and legislations and protect the rights of either shareholders or creditors. Consequently, I propose that legal framework is the most important factor in addressing the agency problem. Lastly, I will comment on the effects of institutional reform on the different types of firms: domestic state-owned, domestic private and foreign firms in transition economies.

The Agency Problem
The traditional view of the firm as one entity no longer stands as finance separates from management. The contractual view of the firm developed by Coarse, Jensen, Meckling and Fama provides the background to investigating this separation of cash flow and control right. As managers have to raise finance to fund their projects and financers do not have the specialised knowledge to generate returns on their finance, the two parties enter into a contract where financers entrust the managers to invest their money in a profit generating way. However, because of information asymmetry: managers are better qualified and have more information about the business, they have considerable level of residual control right which in turn give them discretion to allocate funds in an opportunistic way. Since as soon as investors part with their fund, it becomes a sunk cost to them, they must be protected from opportunistic behaviours such as direct expropriation of fund, transfer pricing and pursuit of projects or perquisites that serve managers’ own interests. I will investigate below the many attempts to align managers’ interests with investors’ in hope to improve performance expressed as productivity concerning insiders and productivity concerning external shareholders.

Pro-market reforms: Liberalisation of product, labour and capital markets Cuervo-Cazurra and Dau argue that pro-market reforms alone diminish agency costs without any need in ownership alteration. We will discuss three main areas of reforms, first, let us look at the how product market liberalisation helps to reduce agency cost. It is relatively easy (maybe not so in the political sense) to lift restrictions on imports, foreign investment and barriers to entry in order to encourage more intensive competition in the market. Competition ensures that less performing businesses will be forced out of the market therefore, it will be in the manager’s interest to improve productivity. Nonetheless, managers might set...
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