Agency Theory: Principal Agent Model

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2.3. Agency Theory
Agency Theory (AT) is often applied in order to explain certain phenomena in the context of franchising (e.g. Brickley and Dark, 1987; Carney and Gedajlovic, 1991; Doherty and Quinn, 1999). This section therefore deals with some aspects of AT such as the principal-agent model, AT’s application in franchising, agency problems and costs, and it lists measures to remedy those issues.
2.3.1. The Principal-Agent Model
Agency Theory emerged as a number of economists such as Arrow (1970) and Wilson (1968) explored risk-sharing among individuals and groups in the 1960s and early 1970s. The initial framework explained that risk-sharking problems occur when participants have diverging attitudes towards risk. AT added to this concept
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Agency Problems
Generally speaking, agency problems arise in two cases: Either due to a conflict of goals of the principal and the agent, or if it is too difficult or costly for the principal to gather information about the agent’s behavior (Jensen and Meckling, 1976; Ross, 1973).
Information asymmetry lies at the root of agency problems. It occurs due to imperfect market information. Several boundaries such as regulations, economic turmoil, social structures, and culture may inhibit proper transfer of information. Problems may arise due to differences in economic development or regulation between the home country and the host country. Also, cultural practices in the host country might differ from those in the home country, which can also compound the issues (Doherty and Quinn, 1999). Information asymmetry is less of a problem in firms listed on the stock exchange. It can, however, turn into an issue for companies with large amounts of intangible assets such as brand name, advertisement, and research and development (Hutchinson,
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2.3.4. Agency Costs
According to Jensen and Meckling (1976), there are three types of agency costs: monitoring expenditures (incurred by the principal), bonding expenditures (incurred by the agent), and residual loss.
The principal’s costs of monitoring and observing his/her agent’s activities are known as monitoring costs. They increase due to physical distance in two ways: Employees have to travel greater distances to observe behavior in the host market and they have to invest time and effort into familiarizing themselves with local conditions (Minkler and Park, 1990).
Secondly, the principal will ask his/her agent to spend resources on entering the agreement between the two, which is also known as bonding costs (Hill and Jones, 1992).
Lastly, welfare will be reduced by the divergence between decisions made by the agent and the ones that would lead to welfare maximization. This type of reduction in welfare borne by the principal is referred to as residual loss (Jensen, 2003, p.
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