1. Agency & Partnership Professor Donald J. Kochan Class 2

2. Todays Reading The Economic Theory of Agency: The Principal's Problem Author: Stephen A. Ross Source: The American Economic Review, Vol. 63, No. 2, Papers and Proceedings of the Eighty-fifth Annual Meeting of the American Economic Association (May, 1973), pp. 134-139 Stable URL: http://www.jstor.org/stable/1817064http://www.jstor.org/stable/1817064 The above referenced article can be accessed on TWEN: The above referenced article can be accessed on TWEN: http://lawschool.westlaw.com/DocForums/ViewSingleDocu ment.aspx?postingID=3934900&courseID=71549 http://lawschool.westlaw.com/DocForums/ViewSingleDocu ment.aspx?postingID=3934900&courseID=71549

3. Todays Reading Barry M. Mitnick, Origin of the Theory of Agency http://papers.ssrn.com/sol3/papers.cfm?abstract_id=10203 78# http://papers.ssrn.com/sol3/papers.cfm?abstract_id=10203 78# The above referenced article can also be accessed on TWEN The above referenced article can also be accessed on TWEN

4. Basic Principles First, ask yourself what could the principal do if acting on his own – i.e., what are the extent of his interests and rights. The principal cannot delegate authority to an agent anything he could not do himself. You must start also with not only what the principal COULD do, but also what she is legally MUST do. First, ask yourself what could the principal do if acting on his own – i.e., what are the extent of his interests and rights. The principal cannot delegate authority to an agent anything he could not do himself. You must start also with not only what the principal COULD do, but also what she is legally MUST do. Second, ask what is the SCOPE of the authorization that the principal has given to the agent within this set of the principals legitimate rights and interests -- this defines and instructs and limits the agent Second, ask what is the SCOPE of the authorization that the principal has given to the agent within this set of the principals legitimate rights and interests -- this defines and instructs and limits the agent Third ask yourself if the action exercised by an agent: Third ask yourself if the action exercised by an agent: Was within the agents authority as granted by the principal Was within the agents authority as granted by the principal Was something the principal could have done herself Was something the principal could have done herself What, if any, liabilities to third parties might exist and whether A, P, or A&P are responsible What, if any, liabilities to third parties might exist and whether A, P, or A&P are responsible Remember the principal is in control – she may not have given the agent the power to do everything she may do on her own Remember the principal is in control – she may not have given the agent the power to do everything she may do on her own Intent and Scope in the relationship are key; level of specification is key; specificity of directions to the agent are key; highly fact-specific inquiries Intent and Scope in the relationship are key; level of specification is key; specificity of directions to the agent are key; highly fact-specific inquiries

5. Restatement of the Law Third, Agency – Introductory Definition § 1.01 Agency Defined Agency is the fiduciary relationship that arises when one person (a "principal") manifests assent to another person (an "agent") that the agent shall act on the principal's behalf and subject to the principal's control, and the agent manifests assent or otherwise consents so to act.

6. Why Use Agents Expertise Expertise Specialization/Division of Labor – Why Do Yourself What You Can Employ an Agent to Do Better? Specialization/Division of Labor – Why Do Yourself What You Can Employ an Agent to Do Better? (e.g. isnt that why anyone would hire a lawyer?) See non-required supplemental readings at: Leonard Read, I, Pencil http://www.fee.org/pdf/books/I,%20Pencil%202006.pdf Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, http://www.econlib.org/library/Smith/smWN1.html#B.I,%20Ch.1,%20Of%20the%20Division% 20of%20Labor Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, http://www.econlib.org/library/Smith/smWN1.html#B.I,%20Ch.1,%20Of%20the%20Division% 20of%20Labor http://www.econlib.org/library/Smith/smWN1.html#B.I,%20Ch.1,%20Of%20the%20Division% 20of%20Labor http://www.econlib.org/library/Smith/smWN1.html#B.I,%20Ch.1,%20Of%20the%20Division% 20of%20Labor Reduction of Transaction Costs Reduction of Transaction Costs Reduction of Information Costs Reduction of Information Costs Preferences Preferences Opportunity Costs Opportunity Costs Economies of Scale Economies of Scale Pooling of Assets and Risks Pooling of Assets and Risks

7. Potential Litigation Positions The key relationships require definition between the agreements of Principal and Agent, and then between P&A with their dealings with the outside world. The key relationships require definition between the agreements of Principal and Agent, and then between P&A with their dealings with the outside world. P v. A P v. A A v. P A v. P 3 v. A 3 v. A 3 v. P 3 v. P 3 v. A&P 3 v. A&P

8. Ross on the Principals Problem **You need not focus on the equations, just get the big picture Every principal has an incentive to create any P/A relationship in a manner where the self interests of BOTH P&A are maximized Every principal has an incentive to create any P/A relationship in a manner where the self interests of BOTH P&A are maximized Optimal Structure: Congruence of Interests/Symmetrical Interests/Mutuality of Interests/Mutual Benefits from Relationship Optimal Structure: Congruence of Interests/Symmetrical Interests/Mutuality of Interests/Mutual Benefits from Relationship Incentivizing Agent Behavior Incentivizing Agent Behavior Of course, A has fiduciary duties to P, but that might not lead to maximization unless A also has an interest and investment in maximizing Ps interest Of course, A has fiduciary duties to P, but that might not lead to maximization unless A also has an interest and investment in maximizing Ps interest Thus, fee schedules and other incentive structures may induce agent behavior BEYOND the minimal effort Thus, fee schedules and other incentive structures may induce agent behavior BEYOND the minimal effort Bottom line is that incentives matter; incentives produce results. To the extent the agent maximizes his self-interest by working hard to maximize the principals self interest = best results Bottom line is that incentives matter; incentives produce results. To the extent the agent maximizes his self-interest by working hard to maximize the principals self interest = best results Focus on the efficiency arguments and Pareto optimality Focus on the efficiency arguments and Pareto optimality

9. Concluding Remarks This general introduction is intended to make you realize the Principle/Agent relationships we engage in every day. This general introduction is intended to make you realize the Principle/Agent relationships we engage in every day. That is why next class part of your assignment is to provide 2 examples from your own life. That is why next class part of your assignment is to provide 2 examples from your own life. The other part of this weeks introduction was to familiarize you with the underlying theories that must be considered as we approach specific examples and more complex situations. The other part of this weeks introduction was to familiarize you with the underlying theories that must be considered as we approach specific examples and more complex situations.