Question

According to the ‘optimal contracting’ theory Executive compenstaion is one solution to the agency problem between managers and shareholders.

Critically discuss the agency problem in light of the agency theory and discuss how optimal contracting theory views managers’ pay arrangements as a (partial) remedy to the agency problem.

According to the ‘optimal contracting’ theory Executive compenstaion is one solution to the agency problem between managers and shareholders.

Critically discuss the agency problem in light of the agency theory and discuss how optimal contracting theory views managers’ pay arrangements as a (partial) remedy to the agency problem.

According to the ‘optimal contracting’ theory Executive compenstaion is one solution to the agency problem between managers and shareholders.

Critically discuss the agency problem in light of the agency theory and discuss how optimal contracting theory views managers’ pay arrangements as a (partial) remedy to the agency problem.

According to the ‘optimal contracting’ theory Executive compenstaion is one solution to the agency problem between managers and shareholders.

Critically discuss the agency problem in light of the agency theory and discuss how optimal contracting theory views managers’ pay arrangements as a (partial) remedy to the agency problem.

According to the ‘optimal contracting’ theory Executive compenstaion is one solution to the agency problem between managers and shareholders.

Critically discuss the agency problem in light of the agency theory and discuss how optimal contracting theory views managers’ pay arrangements as a (partial) remedy to the agency problem.

Answer 1

Agent is one who acts & takes decisions on behalf of another, called the principal --in the best interests of the latter.

Same way, managers are said to be in an agency relationship with the shareholders, who are the owners of the company & act in a manner that maximises the latters' wealth , in every action they make or every decision they take.

Most often-times, the managers find themselves , in a conflict of interests between theirs and the shareholders' --in the process of doing what is maximum good for the shareholders, without any compromise or bringing their own interests , to the fore-front---as for example, when finalising any tender for production purposes or fixing any wage contract for acquisition of skilled labor , to increase production, etc.

The problem , is felt more, when managers do not have any sort of incentive to go that extra mile , for the sake of shareholders , when all they get is the fixed salary, as contracted.

This is exactly where the optimal contracting theory , comes into play---

what it means is-- devising employment incentive-schemes fo rmanagers, that are linked to shareholder wealth/value maximisation. As this theory, is of that managers will not work on their own , to maximise the owners' wealth, they need to be cajoled into doing that -- by this carrot & stick approach. So, the Board members step in , and mediate a cost-effectve package, offering incentives to managers ,extra-for-whatever-done -extra basis --at the same time working cost-effective on behalf of shareholders.This is what is ,optimal contracting theory, in essence.

But here, there are certain limitations to the theory itself, that are bound to reduce its effectiveness:

1.Mainly, the Board members themselves are agents the next level and they will also face similar issues.Directors themselves also, may not volunteer to maximise , most of the times, when there are no monetary/non-monetary incentives assured for them.They would just like to stick to their chair. So, in all probability , they would be prepared to go by their superior's pay-package-to- managers and would not like to argue, apprehending de-membering from this Board or for not being invited to other Companies' Boards.

2. Moreover, all of them may not be involved in day-to-day operations of the company , so as to be well-versed to suggest figures & discuss optimal manager-compensation.

3. Optimal contracting with managers is made all the more difficult by various market forces in the labor market--- like compare& contrastwith peers, friends & relatives

4. Offers like golden parachute , ie. Acqiuisition-related compensation for managers of the target company, also have a say on the level of implementation of this theory.

That said, how far this theory can hold good, depends on the board members, who in turn depend on their CEO , who has the ultimate say, including the latters' tenure & fees --as well as both their's shareholder -preferences.