Agency Theory

Agency Theory

Description

Agency theory describes the relationship between principals (shareholders, investors and owners) and agents (management). Theoretical discussions in business and academia may be a modern phenomena, however the dynamics surrounding agency relationships have been around since the dawn of barter and exchange.

Most business relationships are fundamentally agency relationships. In simplistic terms principals have interests and goals to which they have transferred the means, responsibility and some authority to agents with the expectation that their wishes will be carried out. The problem is that the principal's and agent's objectives may not be congruous. Even in the most favorable situations potential for conflicts do exist. To minimize conflicts principals and agents attempt to seek common ground. Principals may offer incentives in an effort to motivate agents. Agents on the other hand may shirk their responsibilities when the believe the working relationship is less than equitable.

Two concepts that are inherent to the agency theory are adverse selection and moral hazard. Both of these concepts are the result of several factors including lack of communication, information, level of risk and uncertainty. Adverse selection occurs when the principals cannot determine if agents are fulfilling his (the principal's) goals or to what extent those goals are being accomplished. Moral hazard results when an agent has no perceived incentive to perform to any set standard, such as in a fixed salary or price contract.

Industry Application

Efforts to mitigate the negative affects of an agency relationship are routinely undertaken in business and industry. Organizations and individuals have attempted to align goals, benefits and risks into mutually supportive arrangements. For example companies may offer bonuses, stocks, ownership and other enticements to encourage the desired performance. Businesses may also withhold items of value such as promotions and pay increases to motivate appropriate behaviors. Principals and agents are in a continual process of building partnerships with the objective in meeting their individual goals. Success in these relationships is often influenced by corporate culture, level of industry maturity, marketplace and other factors.

Analysis