|# / Digitized by the Internet Archive in 2011 with funding from Boston Library Consortium IVIember Libraries http://www.archive.org/details/agencycostsinproOOacem DEWEY J; HB31 .M415 9s-i \/2^. working paper @ department of economics AGENCY COSTSIN THEPROCESS OFDEVELOPMENT Daron Acemoglu Fabrizio Zilibotti 96-8 Feb. 1996 massachusetts institute of technology 50 memorial drive Cambridge, mass. 02139 AGENCY COSTSIN THEPROCESS OFDEVELOPMENT Daron Acemoglu Fabrizio Zilibotti 96-8 Feb. 1996 MASSAWU?'" m^ 13 1996 96-8 Agency Costs in the Process of Development Dciron Acemoglu Fabrizio Zilibotti* Massachusetts Institute Universitat of Technology Pompeu Fabra February 16, 1996 Abstract We analyze an economy where production is subject to moral hazard. The degree of the incentive (agency) costs introduced by the presence of moral hazard naturally depends on the information structure in the economy; it is cheaper is to induce correct incentives in a society which posesses better ex post information. Thedegree ofex post informationdepends on the numberof projects and entrepreneurs in the economy; the more projects, the better the information. This implies that at the early stages of development, the range of projects and the amount of information are limited and agency costs are high. Since the information created by a project is an externality on others, the decentralized economy is constrained inefficient; in particular, it does not 'experiment' enough. The analysis of the role of information also opens the way to an inves- tigation of the development of financial institutions. We contrast the infor- mation aggregation role of stock markets and information production role of banks. Because the amount of available information increases with develop- ment, our model predicts the pattern of financial development observed in practice; banks first and stock markets later. JEL Classification: D82, E44, G20. KeyAvords: Agency Costs, Development, Information, Financial Institutions, Social Experimentation. *WethankAndresAlmazan, AlbertoBisin, RussCooper, PeterDiamond, JohnHassler, Torsten Persson, Sevi Rodriguez-Mora, Mfiria Saez-Marti, Ilya Segal, Jaume Ventura and seminar partic- ipants at Copenhagen, Harvard-MIT, IIES-Stockhohn, UPF, Wharton for helpful comments and Benjamin Levin for excellent research assistance. Zilibotti acknowledges the hospitality of the International Institute of Economic Studies, University of Stockholm, and financial support from the Ministry ofEducation of Spain (DGICYT PB93-0388). 1 Introduction The efficient allocation of resources reqmres that many tasks be delegated to agents who are not the full residual claimants of the returns they generate. It is therefore natural that agency relations play an important role in many accounts of economic development [e.g. Mydral, 1968, North, 1990] and that high agency costs faced by some Third World societies have been argued to prevent their economic development [e.g. North, 1990, p. 59]. The change in the factory system at the time of the British Industrial Revolution [see Mokjn:, 1991, for discussion], or the emergence of hierarchical organizations and professional management [see Chandler, 1977] are among the agency relations that seem to have played an important role in the process of development. Perhaps the most important example of agency relations is in the credit market. Entrepreneurs borrowing funds for their activities need to be given the right incentives. It is well-known that financial intermediation was limited at the early stages of development, and economic growth and the growth of intermediated fimds went handinhand over thepast three centuries [e.g. Goldsmith, 1969, Kennedy, 1987, King and Levine, 1994]. For instance. Goldsmith (1987) shows that in most pre-modern societies financial arrangements were extremely informal, and the same pattern arises from Townsend's (1995) study ofIndian villages. These observations suggest that societies at the early stages of development were unable to have wide-ranging agency relations and relied predominantly on family or village ties to raise funds and ensure enforcement. This situation contrasts with the more developed and complex credit relations that we observe today. A number of other features related to the evolution of incentive contracts and agency relations are also relevant to our investigation. First, wliile at the early stages most firms were owner managed, the majority oflarge firms today have man- agement separated from ownership. This suggests that the 'high powered' incentives of the owners have been replaced by the weaker incentives ofcurrent day CEOs [e.g. Berle and Means, 1932, Jensen and Meckling, 1976]. Moreover, even when attention is restricted to professional managers only, the same pattern emerges. Jensen and Murphy (1990) show that the pay-performance sensitivity for CEOs has decreased substantially since the 1930s^ Second, while in less developed external financing re- ^Unable to explain this pattern using any existing theory, Jensen and Murphy suggest that this is due to political constraints. However, an impUcation of this explanation is that non-monetary methods ofcontrolshould be used more often and thus current day CEOs should be replaced more frequently for poor performance. In contrast, Haddlock and Liuner (1994) find that the likeUhood