Agency Theory & Agency Problem Explained

Agency Theory is the framework that explains the relationship between business principal and their agents. and Agency Problem is a specific issue that can arise within that framework.

What is the Agency Theory?

Agency Theory is a framework that explains the relationship between business principals (who hires someone) and their agents (who acts on the principal’s behalf).

The theory suggests that the separation of ownership and control of the firms leads to conflicts between shareholders and management teams.

The main problem in agency theory is whether managers work towards the best interests of shareholders. This theory assumes that the principal and agent may have conflicting interests. Managers can maximize their self-interest at the expense of profit when ownership and control are separated, which will create agency costs.

What is the Agency Problem?

The agency problem (also known as the principal–agent problem) is a specific issue that arises from a core assumption of agency theory.

In a principal–agent relationship, the ‘Agent’ (person or entity) takes the decision and the Principal ‘receives the benefits’ from the actions.

An agency problem occurs when an agent works in a manner that does not benefit the principal as much as intended.

This can happen due to:

• Divergent Goals: The principal may want more profits but the agent might want to prioritize job security.
• Information Asymmetry: The principal might not have complete information about the agent’s motivations.
• Moral Hazard: The agent might act unethically or take more risk as the principal bears the consequences.

Agency Problem is commonly observed in the following cases:

• Shareholders (principal) vs. management (agent)
• Financial institutions (principal) vs. rating agencies (agent)
• Voters (principal) vs. politicians (agent)

The agency problem is important in understanding the theory of the firm because there are times when decisions taken by the agent may not be for the goal of maximizing profits for the company. Some agents may not act in the best interests of the principal, the disagreements may result in inefficiencies which may result in financial losses. More the agent’s actions diverge from the principal’s best interests, more the agency loss becomes.

Agency Theory is based on a conflict between shareholders wanting the best return on their investment and managers wanting remuneration, recognition etc. It can affect other aspects of running a successful business such as:

• Employee pay and reward
• Sickness absence policies and pay
• Legislation for other types of leave e.g. maternity leave
• Holidays
• Donating time or money to charities/local groups
• Health and safety legislation

Solutions

In order to avoid this problem, it is important to design contracts, compensation structures, and monitoring mechanisms that align the interests of both the parties and helps achieve the principal’s goals.

Good Corporate governance can help in such cases.

• Incentives that encourage wrong behavior by Agents must be removed, and rules discouraging moral hazard must be in place.
• Agents must be given other incentives that will encourage them to act in the interest of the principal.
• Several experts see the separation of security ownership and control (especially in case of massive organizations) is seen as an efficient form of economic organization.

It is significant for a company to have an independent board of directors to influence the management team to achieve the highest firm performance. The majority of outside directors on boards can monitor firm executives to mitigate managerial opportunism and give appropriate incentives to them to promote shareholder value.

Read: Theory of the firm: maximize profits