Agency Theory

MoneyBestPal Team
A concept that explains the important relationships between principals and their agents.

A theory known as agency theory explains the crucial connections between principals and their agents. Principals are people who provide their agents, who act on their behalf, authority, or decision-making power. 

Although agents are required to act in the principal's best interests, they occasionally may have divergent objectives or preferences. As a result, there could be an issue known as the agency problem or agency conundrum.

The agency problem appears when there is an incentive misalignment or when principals and agents have different levels of risk aversion. For instance, shareholders (principals) might desire managers (agents) to invest in lucrative projects that raise the company's worth, but managers might choose to do so in less-risky ventures that serve their own interests. Similarly to this, investors (principals) may desire fund managers (agents) to maximize their profits, while fund managers may want to diversify their portfolios or impose excessive fees that lower the investors' net returns.

Agency theory attempts to explain and resolve these disputes by designing mechanisms that align the interests of principals and agents. Contracts, performance-based pay, monitoring, bonding, reputation management, and corporate governance are a few examples of these methods. The objective is to lower agency costs, which are expenses borne by principals as a result of the conflicting interests or actions of agents. Monitoring costs, bonding costs, residual loss, and opportunity costs are just a few examples of agency expenses.

Economic, financial, accounting, management, legal, and political science are just a few of the disciplines where agency theory has been extensively used. It has aided in the understanding of a number of phenomena, including corporate governance, executive compensation, capital structure, dividend policy, mergers and acquisitions, financial intermediation, auditing, regulation, and public policy. A significant corpus of empirical research has been produced by it as well, testing its hypotheses and ramifications.

However, agency theory is not without limitations or criticisms. Some of the challenges faced by agency theory are:
  • Measuring and keeping track of the deeds and results of principals and agents
  • Having to work with numerous principals or agents who have various preferences or expectations
  • The consideration of informational imbalance, moral hazard, and adverse selection
  • Considering how ethics, society, social norms, and trust play a part
  • Understanding the dynamics of principal-agent relationships and their complexity
  • Balancing the compromises between equity and efficiency

Agency theory is an important, yet controversial, theory that provides a useful framework for analyzing and designing principal-agent relationships. It is beneficial to pinpoint the causes and effects of agency issues and to provide solutions that balance the interests of principals and agents. It does, however, have significant drawbacks and qualms that call for improvement and extension.