Moral Hazard and Agency Theory:

The moral hazard or agency-theory approach seeks to separate the ownership and control. Surveying the range of contracts observed in the economy with respect to incentives and cooperation, it generalises a range of relationships i.e. from employment contracts to the various other more complex relationships that make up the firm. The theory points out to the need for effective incentive alignment to promote smooth transaction among the- different agents involved. As both the principal and the agent are opportunists seeking to minimise production/transaction costs while at the same time trying to maximise their benefits, the theory emphasises the need for flexible means of coordinating activities. Advocating vertically integrated (i.e. unified ownership) organisational structures with features of simple spot contracts, franchises or joint ventures, the theory claims that such arrangements provide discrete structural alternatives. The theory is critiqued to suffer from characteristic weaknesses like the 'proliferation of influence activities'. Referring to the self-interested behaviour of influential segments (i.e. the agents involved directly and other external influential segments like politicians, bureaucrats, and others), the theory points out that owing to the capturing of increasing portions of resources by powerful interest groups, institutional rigidities develop impacting adversely on the performance of the firms.

To ease the situation arising on account of institutional rigidities, the agency theory focuses on the design of ex-ante incentive-compatible mechanisms. It thereby seeks to reduce agency costs in the face of potential moral hazard by agents. Jensen and Meckling (1976) define agency costs as the sum of: (i) the monitoring expenditures of the principal; (ii) the bonding expenditures by the agent; and (iii) the residual loss. The residual loss represents the potential gains from trade not realised due to the principal's inability to provide incentives for agents. In a typical agency model, a principal assigns an agent a task, but has only an imperfect signal of the agent's performance. The optimal incentive contract balances the principal's desire by giving the agent
incentives to increase efforts insuring also for the agent's fluctuations in compensations from factors beyond his control.

Thus, in the agency literature the firm is an entity signifying a collection of contracts between owners and managers. managers and employees, the.firm and its customers/suppliers. The focus on the firm is limited but significant to the extent that it brings the conflicting objectives of individuals into a desired state of equilibrium within a framework of contractual relations.