The Use of Agency Theory to Analyze Problems in Ryanair Company

Introduction

When analyzing the case of Ryanair mistreating their employees and applying the relevant economic theory, it is clear that agency theory is evident here. An agency relationship consists of an agreement under which one party, the principal, engages another party, the agent, to perform some service on the principal’s behalf (Brickley & Smith, 2002). In this case, Michael O’Leary would be the principal, and the agents would be the pilots. Ideally, the incentives of both the principals and agents would be aligned. However, in this scenario, the agents/pilots had contracts that were unfair, and they were expected to pay for their own training. This was deemed insufficient compensation for the pilots, and the public image of Ryanair suffered.

The Use of Agency Theory to Analyze Problems in Ryanair Company

Using agency theory, we can deduce that Michael O’Leary is seeking to maximize profits for some personal gain, i.e., he will receive a bonus if certain financial targets are met. Agents have their own incentives to protect their welfare if it comes under threat, even at the expense of the principal. This is clearly evident in the case of Ryanair. We can assume the reasoning behind the decisions taken by those involved as actors within the Principal/Agent relationship have information about themselves that others couldn’t possibly know about. This information deficit between players can be costly to firms. When information is distributed unevenly, those with a higher degree of information can engage in opportunistic behavior.

It is unclear why O’Leary chose to contract his pilots in this manner, but he showed a complete disregard for their basic needs. Economics is all about trade-offs, and this is an example of trading off a decent working environment/customer service with maximizing profit. It could also be a way for Ryanair to increase their customer base, and this idea is explored in a related paper. “Firms seek to signal that its costs are low and thus that it is worthwhile for customers to trade with it in the future as their prices will be low as well” (Bagwell, 1986).

Consequences and Recommendations

It is clear from analyzing Ryanair’s problems using agency theory that for the airline to continue to operate successfully in the market, things have to change. As explained above, if other airlines are able to offer better contracts for pilots, they will seek opportunities elsewhere, which not only loses the company money due to flight cancellations, but the constant negative publicity surrounding the company will not become a thing of the past.

Ryanair needs to properly compensate their workforce, or their rivals will benefit, so paying this extra money will perhaps not benefit Ryanair in the short term, but long term, they can develop a new image for themselves. Ryanair could also spend more money on adequately training not only their pilots but flight attendants also, to make sure that incidents like the video that went viral last week are prevented in the future. If a boycott actually does take place, then this could cost Ryanair millions, again proving that spending money in the short term and improving their image will save them money in the long run.

Agency Theory and the VW Case

After reflecting on the economic theory used in this case study, it is clear that the management and shareholder layout of VW make it “reasonable to urge the adoption of an agency theory perspective when investigating the many problems that have a principal-agent structure” (Eisenhardt, 1989). One of the main principles of agency theory is that people will act rationally; however, this is not always the case. Sometimes people will act irrationally, often for their own potential gain. Ariely supports this; “irrationality is the real invisible hand that drives human decision-making”. With regards to the VW case, there is no way to know if the CEO and other managers were acting rationally or not, therefore there isn’t full reliability of the solutions formed from agency theory. Using agency theory to analyze the VW case may provide more accurate solutions if we also take behavioral economics into consideration and understand that people do not always act rationally.

Agency theory assumes human nature is ruled by self-interest (Perrow, 1986). VW management acted in self-interest when using malware to decrease emission readings; their goal was to reap the profits of a ‘green car’ without taking on the costs of production. This may appear to fit with the VW case, but the underlying assumption may be too simplistic. Agency theory is underpinned by the beliefs that people are rational, consumption maximizing, ruled by self-interest, and have fixed preferences. I have commented already on the issue of rationality, but the problem is that the main assumptions used in the economic model are oversimplified and unrealistic (Hirsch, Michaels, & Friedman, 1987). Agency theory is too simple and ignores the complexity of organizations; therefore, it is limiting in application to the VW case.

In the report, aligning remuneration policy with long-term company performance was suggested as a possible solution to the agency theory problems faced by VW. We suggested offering stock options as an alternative to bonuses; however, there is evidence to suggest that this does not always eliminate the problems. DeFusco, Johnson, and Zorn (1990) find that stock-price volatility increases, and traded bond prices decrease, after the approval of executive stock option plans; in other words, offering stock options to management can also be linked to increased risks. Also, the incentive can be lost if the stock price falls; therefore, it cannot be a complete solution.

Conclusion

In conclusion, Agency Theory can be used to analyze the problems in the VW case; however, there are many limiting factors. According to Eisenhardt (1989), agency theory research can be improved by applying it alongside other relevant theories. In the VW case, if I combine agency theory with behavioral economics, or possibly institutional theory, which was shown to be effective by Conlon and Park (1990), the economic problems can be better solved.

References

• Bagwell, K. (1986). Firms seek to signal that its costs are low and thus that it is worthwhile for customers to trade with it in the future as their prices will be low as well.
• Brickley, J. A., & Smith, C. W. (2002). Agency Theory and the Problem of the Firm.
• DeFusco, R. A., Johnson, R. R., & Zorn, T. S. (1990). Stock Price Volatility and Executive Stock Option Plans.
• Eisenhardt, K. M. (1989). Agency Theory: An Assessment and Review. Academy of Management Review, 14(1), 57-74.
• Hirsch, P. M., Michaels, S., & Friedman, R. (1987). Clean Models vs. Dirty Hands: Why Economics is Different from Sociology. In: Sociological Forum, 2(1), 39-54.
• Perrow, C. (1986). Complex Organizations: A Critical Essay.