Theory of the Firm

The theory of the firm, a microeconomic concept (in neoclassical economics), states that a company’s main goal should be to maximize profits, to create as big a gap between revenue and costs as possible by allocating resources to maximize net profits.

The theory of the firm influences decision-making in several business areas, including resource allocation, production techniques, pricing adjustments, and the volume of production.

Modern perspective to the theory of the firm distinguishes between long-run motivations (such as sustainability), and short-run motivations (such as profit maximization).

What is the Agency Problem?

The agency problem (also known as the principal–agent problem), on the other hand, is a conflict of interest usually seen in any relationship where one party is expected to act in another’s best interests.

In such relationships, the person or entity (the ‘Agent’) takes the decision and the Principal ‘receives the benefits’ from the actions. The problem (or the dilemma) occurs when agents act in their own best interests, which could be contrary to those of their principals. This is an example of a moral hazard.

Agency Problem is commonly observed in the following cases:

• Shareholders (principal) vs. management (agent)
• Financial institutions (principal) vs. rating agencies (agent)
• Voters (principal) vs. politicians (agent)

The agency problem is important in understanding the theory of the firm because there are times when decisions taken by the agent may not be for the goal of maximizing profits for the company. Some agents may not act in the best interests of the principal, the disagreements may result in inefficiencies which may result in financial losses. More the agent’s actions diverge from the principal’s best interests, more the agency loss becomes.

Agency Theory is based on a conflict between shareholders wanting the best return on their investment and managers wanting remuneration, recognition etc. It can affect other aspects of running a successful business such as:

• Employee pay and reward
• Sickness absence policies and pay
• Legislation for other types of leave e.g. maternity leave
• Holidays
• Donating time or money to charities/local groups
• Health and safety legislation

Good Corporate governance can help in such cases.

• Incentives that encourage wrong behavior by Agents must be removed, and rules discouraging moral hazard must be in place.
• Agents must be given other incentives that will encourage them to act in the interest of the principal.
• Several experts see the separation of security ownership and control (especially in case of massive organizations) is seen as an efficient form of economic organization.

Stewardship Theory

While Agency theory is focused on economic and financial outcomes and control, Stewardship theory focuses on how managers behave; Stewardship theory is driven by trust, engagement and a focus on mutual interests.

Managers are motivated by satisfaction gained from doing their job well and they consider themselves part of the organisation and have strong sense of duty towards it.

Although managers want to receive good reward for their work, they do not want this to be at the overall expense of the organisation.

This leads to alignment with the organisation’s interests, and consequently their behaviour is aligned to organisational interests and reputation.

This reduces or eliminates conflict between managers and shareholder.