Agency Costs and the Setof Contracts Perspective

The set-of-contracts theory of the firm states that the firm can be viewed as a set of con-tracts.5 One of the contract claims is a residual claim (equity) on the firm's assets and cash flows. The equity contract can be defined as a principal-agent relationship. The members of the management team are the agents, and the equity investors (shareholders) are the principals. It is assumed that the managers and the shareholders, if left alone, will each attempt to act in his or her own self-interest.

The shareholders, however, can discourage the managers from diverging from the shareholders' interests by devising appropriate incentives for managers and then monitoring their behavior. Doing so, unfortunately, is complicated and costly. The cost of resolving the conflicts of interest between managers and shareholders are special types of costs called agency costs. These costs are defined as the sum of (1) the monitoring costs of the shareholders and (2) the costs of implementing control devices. It can be expected that contracts will be devised that will provide the managers with appropriate incentives to maximize the shareholders' wealth. Thus, the set-of-contracts theory suggests that managers in the corporate firm will usually act in the best interest of shareholders. However, agency problems can never be perfectly solved and, as a consequence, shareholders may experience residual losses. Residual losses are the lost wealth of the shareholders due to divergent behavior of the managers.

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