Agency Theory

Topics: Principal-agent problem, Stock, Asymmetric information Pages: 7 (1480 words) Published: May 9, 2015

An agency in general, is the relationship between two parties, where one is a principal and the other is an agent who represents the principal in transaction with a third party. Agency relationship occur when the principal hire the agent to perform a service on the principal behalf. In common, principal will delegate decision making authority to the agent. Agency Theory is concerned with resolving problems that may exist in agency relationship; that is, between principals (such as shareholders) and agent of the principals (such as company executive). The two common problems that agency theory addresses are: 1) the problem that arise when the goals of the principal and the agent are in conflict. 2) the problem that arise when the principal and agent have different attitudes towards risk.

Because of different risk tolerances, both principal and agent may each be refused to take different action. Agency problems may arise because of inefficiency and incomplete information. A simple agency model suggest that, as a result of information asymmetries and self-interest principals lack reasons to trust their agent and will seek to resolve these concerns by putting in place mechanism to align the interests of agents with principals as well as to reduce the scope of information asymmetries.


At times, agent and principal are prone to have different motives. They may be influenced by factors such as financial rewards, labour market opportunities, and relationships with other parties that are not directly relevant to principals. Agents may also be more risk averse than principals. As a result to these differing interests, agents may have an incentive to bias information flows.

Principal’s Problems
Since principal has delegated the authority and responsibilities to agent, principal depends on agent’s effort, and possibly other factors to determine his/her profit. Earning maximum profit would be the main interest of the principal. However, the agent also would like to maximises his/her utility. Doing work is a disutility, so agent needs compensation to be induced to work. Besides that, agent may require a minimum level of utility before agreeing to work. This contradict with principal’s objective, which is to maximize his profit.

Profit = Revenue generated by agent – payment to agent

Agent’s Problems
Agents are somewhat the same like principal. They would also like to maximize their utility. When such intention arises, it will compromise the principal’s interest. For example, in dealing with a high risk business contract the has possibility high return, managers might as well avoid such contract because they are afraid of the negative impact on them (no bonuses, being laid off, etc.) should the contract fails. However, the managers action is not in the best interest of the principal. Agent’s objective is not aligned with principal’s.

Problems arise when the goals of principals are not completely shared by their agents. For example, employees may exert insufficient effort, or managers may waste organizational resources. The costs that arise when agents fail to act in the interest of principals are called agency costs. The table below explains further:

General agency cost
Specific examples
Losses from poor decisions
Agents may not expand the effort needed to gather appropriate information and make good decisions Purchasing poor-quality raw materials
Investing in an unprofitable project
Not prioritizing projects by attributes that would benefit the entity

Losses from incongruent goals
Agents do not value the same goals and objectives as principals Consumption of perquisites such as expensive offices and travel Excessive executive pay
Underinvestment in projects that are in the principal’s best interest

Monitoring costs
Costs to monitor agents’ behavior and to provide...
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