Applying Agency Theory & the Concept of Corporate Governance

APPLYING AGENCY THEORY & THE CONCEPT OF CORPORATE GOVERNANCE TO JUSTIFY ALTERNATIVES TO PROFIT MAXIMIZATION BY FIRMS

In an era of increasing attention to the demands of multiple stakeholders, the principal objective postulated by the traditional theory of the firm profit maximization increasingly is being challenged. This study considers the justification for possible alternative objectives the profit maximization. This consideration is made within a theoretical framework of agency theory and the concept of corporate governance.

Economists use agency theory to study problems related to motivating and controlling cooperative action. Principals, especially in corporate organizations, require agents to conduct business and seek planned outcomes (Ghatak, Healey, & Jackson, 1998). Agents themselves, thus, must be motivated through incentives to perform for principals. Agency theory argues that shareholder interests require protection that is provided through a separation of roles between the board of directors and executive management. By contrast, the stewardship theory of corporate governance holds that shareholder interests are maximized by integrating the roles of these two bodies (Nicholson, 1998).

The traditional interpretation of the theory of the firm holds that the principal objective of corporate management is to maximize profits. Indeed, some economists, such as Milton Friedman, hold that the maximization of profits is the only objective of corpo

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the contemporary corporate environment. Such behavior is induced by a preoccupation with short-term profit center performance, which is the incentive created for division managers (Gomez-Mejia & Balkin, 1992). The immediate effect is to improve the reported profitability of the division, but that outcome is achieved by risking the long-term position of the enterprise (Lamm-Tennant & Collins, 1994). Having stated that financial entrepreneurship as an agency problem is the product of a combination of profit-center performance measurement and emphasis by top management on short-term growth, the question which must, in turn, be answered is that explaining the emphasis in contemporary American corporations on short-term growth and performance. Several analysts have identified significant reasons why contemporary American corporations emphasis short-term growth and performance. First, prior to the 1970s, there was in American corporations less pressure for short-term performance (Lynn & Rao, 1995). Under the legendary Alfred Sloan, General Motors, as an example, recognized that, for a cyclical business, an appropriate goal needed to be defined as an average over the entire business cycle. In the 1990s, however, corporate managem

Category: Business - A