Definition Definition

Agency Theory

 There is a separation of the owners (principals) and the managers (agents) of a firm, the potential exists for the wishes of the owners to be ignored. This fact and the recognition that agents are expensive, established the basis for a set of complex but helpful ideas.

So, Agency theory is a set of ideas on organizational control based on the belief that the separation of the ownership from management creates the potential for the wishes of owners to be ignored.

According to J.C. Vanhorne said” Agency is a branch of economics relating to the behavior of principles(such as owners) and their agents(such as managers).”

Agency theory is the analysis of how asymmetric information problems affect economic behavior.

Agency theory is the analysis of principal-agent relationships, in which one person, an agent, acts on behalf of another person, a principal.

Agency Theory Definition

Agency theory is a subject of finance and economics that discusses the principal-agent relationship. The principal is the person who hires an agent to complete work on their behalf, whereas the agent is the person who completes the task. This theory gives a framework for studying and comprehending the two parties' relationships and how they influence decision-making.

Understanding the Term

Agency theory is concerned with the alignment of interests between the principal and the agent and how this relationship influences both sides' conduct. In many cases, the principal's and the agent's interests are not aligned, which can lead to conflicts of interest and actions that are not in the principal's best interests. As a result, what is known as the "agency problem" may arise. 

There are two main assumptions behind the rise of the agency problem. 

  1. Both principal and agent are acting for their benefit and self-interest. 
  2. The principal has less information than agents, which questions the principal’s decision-making capacity. 

Because of these two assumptions, we might often see a conflict of interest between them. Agency theory approaches a solution by understanding these problems and mitigating them. 

Types of Agency Theory Problems

  • Owner-Manager

 The problem arises between the company owner and the manager running the operation. Here principal is the owner, and the agent is the manager.

  • Government-Contractor

 Here the problem arises between the government and the contractor who provide logistics support to the government. Government is the principal here, and the contractor is the agent here.

  • Stockholder-Management/CEO

 Here the problem arises between stockholders and the management team. Here the principal is a stockholder, and the agent is the management team.

  • Client-Advisor

 Here the principal is the client, and the agent is the advisor. Here problem occurs between a client and their personal or financial advisor.

Agency Theory Examples

Example 1

The CEO may be more interested in growing their compensation or securing their position in the company, whereas shareholders may be more concerned with maximizing their investment return. This conflict of interest can be managed through performance-based remuneration, in which the CEO's income is connected to the firm's performance, or through monitoring and control measures, such as regular reporting and audits.

Example 2

The investment banker may be more interested in earning a hefty fee, whereas the customer may be more concerned with obtaining the best potential investment return. This conflict of interest can be resolved through clear communication and expectations between the investment banker and the client, as well as through performance-based remuneration, in which the investment banker gets paid a part of the client's investment results.

In sentences

  • In principal-agent interaction, agency theory describes the interaction between a principal and an agent.
  • Agency theory suggests solutions to match the aims of both parties through incentives and monitoring.
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