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The Principal-Agent Problem

bulletThe separation of ownership and control is a distinguishing feature of the modern corporate form of economic organization [see Adolph Berle and Gardiner Means. The Modern Corporation and Private Property, 1934. Also see Means. The Corporate Revolution in America, 1964].
bulletThe shareholders (or "principals") of large, publicly (or widely) -held corporations have nothing to do with the day-to-day operations of firm and have little, if any, influence with respect to major strategic or policy decisions. Operational and decision-making authority within the firm is held almost exclusively by professional managers (the "agents").
bulletThe principal-agent problem arises if the interests or priorities of shareholders and managers do not perfectly coincide. That is, "principals" are (presumably) interested in profits (or shareholder value/ stock price performance) whereas agents may be derive "utility" from a number of factors including growth, power, executive compensation and perquisites, and size of the organization.
bulletIf elements other that profits (or shareholder value) enter into the managerial "utility function," then principals may incur agency costs as measured by the difference between actual and potential profits (or actual and potential market valuation of shares).

Measuring Agency Costs

Let the managerial utility function be given by:

U = U(Profits , Sales)

Where U is utility or satisfaction realized by managers or agents, a function of profits (or the present value of the future stream of profits) and "Sales" , where sales are gross sales of the company in period t. Note that shareholders derive utility from profits only.

bulletClick here to view managerial indifference curves
bulletClick here to view the measurement of agency costs

Moral of the story: A merger often results in the replacement of an incumbent management group with a new regime that is more responsive to the interests of shareholders. Diminishing agency costs are (ostensibly) reflected in the post-merger share price. [For a non-technical elaboration of this view, see Andrei Shleifer and Robert Vishny, "Value Maximization and the Acquisition Process," Journal of Economic Perspectives, Winter 1988:7-20].

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