Handbook on the Economics and Theory of the Firm
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Handbook on the Economics and Theory of the Firm

Edited by Michael Dietrich and Jackie Krafft

This unique Handbook explores both the economics of the firm and the theory of the firm, two areas which are traditionally treated separately in the literature. On the one hand, the former refers to the structure, organization and boundaries of the firm, while the latter is devoted to the analysis of behaviours and strategies in particular market contexts. The novel concept underpinning this authoritative volume is that these two areas closely interact, and that a framework must be articulated in order to illustrate how linkages can be created.
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Chapter 11: Agency Theory, Corporate Governance and Finance

Hong Bo and Ciaran Driver


Hong Bo and Ciaran Driver 11.1 INTRODUCTION The Principal–Agent (P–A) relationship operates when a party, the principal, contracts or instructs the other party, the agent, to perform a delegated task. At the centre of the P–A relationship is the assumption that both parties are utility maximizing and agents are extrinsically motivated and opportunist. The assumption on the agent matters because of uncertainties involved in observing the agent’s action by the principal. Moral hazard problems (such as low effort) and adverse selection problems (such as taking advantage of information held only by the agent) are likely to arise, and there can be no presumption that the parties will find an arrangement to reach the first best solution that would be possible in the absence of these distortions. Corporate governance is an institutional form that addresses this problem; the costs incurred in setting up these governance mechanisms form part of what are known as agency costs. The context of the P–A relationship can range from the management of an entrepreneurial firm to regulatory rules for education, policing or care services. Although widely applied, agency theory originated in a consideration of the separation of ownership and control in the modern corporation (Jensen and Meckling, 1976). Shareholders are principals and managers are agents. Shareholders are held to maximize firm value, while managers, if assumed to be self-interested, may have other goals; instead they intend to derive private benefits by managing the firm. How to resolve that issue to the benefit...

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