Estimating Managers' Utility Maximizing Demand for Agency Goods

An empirical model of managers' demand for agency goods is derived and estimated using the Almost Ideal Demand System of Deaton and Muellbauer (AER 1980). As in Jensen and Meckling (JFE 1976), we derive managers' demand for agency goods by maximizing a managerial utility function where managers allocate the potential value of their firm's assets to the consumption of agency goods and the production of market value (which, given their ownership stake, determines their wealth). The utility function is defined over wealth and the value of agency goods and is conditioned on managers' holdings of stock options, the proportion of the firm owned by outside block-holders, and the firm's capital structure. We obtain the maximum potential value of firms' assets by fitting a stochastic frontier (upper envelope) to the market value of assets given the investment in those assets. The difference between the potential market value of a firm's investment in its assets and their actual market value (corrected for statistical noise) is used to gauge managers' consumption of agency goods. The demand function for agency goods (lost market value) is estimated using U. S. data on publicly traded bank-holding companies. Using the adding-up condition, the demand for asset value is derived from it and restated as the utility-maximizing Q ratio. We apply Slutsky's equation to decompose the effect of a variation in the proportion of the firm owned by managers into a substitution and a wealth effect, which parallel the alignment-of-interest effect and the entrenchment effect. By estimating financial performance in a choice-theoretic framework, the alignment and entrenchment effects of ownership can be identified econometrically. We find evidence that the strength of both effects increases with insider ownership, but ownership by outside block-holders mitigates the entrenchment effect.