What Is Agency Theory? Types, Pros & Cons
by Shahnawaz Alam Job & Career 07 September 2023
Agency theory involves principles and agents in a relationship that binds their relationship based on the principal’s interests. The agents carry out the tasks delegated by the principals. However, it is also common for agents to diverge from the principal’s interests, initiating a conflict of interest.
So, how does agency theory outline organizational conflicts? And how does it define the relationship between the agents and the principals? Keep reading this article to find out your answer.
What Is Agency Theory?
Agency theory deals with the principles that pay attention to the relationship between principals and agents. According to this theory, there are two entities – the principals and the agents. The principal is a superior entity that delegates specific tasks among the agents.
These roles can change across different settings like business and politics. In business, the shareholders are the principals. In the political context, elected representatives are the agents, and their constituents are the principals.
In the corporate sector, the agency theory points to the term’ conflict of interest.’ If the agents are not acting according to the interests of their principals, then there might be internal conflict inside the organization. Conflict of interest can stem from incompatible desires. The result is usually financial loss or the loss of the principals.
Undoubtedly, the agency theory is something one should keep in mind. Go through this article if you want to learn about it.
What Is Agency Theory? Explained
The agency theory or the principal agency theory deals with the process of task delegation among the agents by the principles. This theory also explains the issues and solutions regarding task delegation. William Meckling and Michael C. Jensen popularized the agency theory.
According to this theory, the principals delegate specific tasks to their agents with the necessary authority and autonomy to finish the job in time. Conflict between the agents and the principals is familiar but unwanted.
Such issues or conflicts usually arise because of the agents’ and principals’ conflict of interest. Another reason can also be information asymmetry.
The agency theory exists to minimize the possibility of conflicts of interest or information asymmetry. It promotes building a relationship between the agents and the principals.
Things To Remember
Multiple studies have focused on detailing different scenarios under which the agents may diverge from the principal’s interests. These studies also outline different governance frameworks that would restrict the self-serving intentions of the agents. It also ensures that the agents always align themselves with the principal’s interests.
For example, the agent can usually operate in the best interest of the principals if the agreement between them is based on an outcome. Also, the agent can work in the best interest of the principals, with the principals having information to verify the agent’s action.
The expert principal-agent researchers focus on the principal-agent interactions and help create an ideal contract between them. The most effective contract between the agents and the principals is the behavior-based contract.
The principal purchasing the agent’s conduct in the situation is the reason behind it. The agent is also presumably more risk-averse compared to the principals. That is why an outcome-based contract easily passes the risk to the agent.
Types Of Agency Theory Relationships
The agency theory is really helpful for keeping an effective contract between the agents and the principals. Here are different types of relationships under the agency theory –
Shareholder & Company Executive
The most common agency theory relationship outlines shareholders of a company and the company executives in a principal-agent relationship contract. The investors of the company or the shareholders are the principals. The agents are the company executives who run the company and are funded by the principals (shareholders).
The management of the company can make a remarkable impact on investment. Hence, the farm management needs to make a wise and apt decision.
Board Of Directors & CEO
Another type of agency theory relationship is visible between a CEO and the board of directors. In this case, the CEO is the agent, and the board of directors is the principal. The board of directors is there to support the CEO if they are able to make profitable decisions.
The flip side of this agency theory relationship suggests that the CEO can initiate a conflict of interest by following their own interest, which hurts the company’s financial health.
Investor & Fund Manger
If you are familiar with the mutual fund landscape, then you know the role a fund manager and an investor plays. According to agency theory, the fund manager is the agent, and the investor is the principal. The fund manager is an individual who receives a commission based on the average asset under their management (AUM).
The outcome-based relationship here prompts the fund manager to work according to their principal’s interest (increasing profit). But, if they were to report loss or less profit, then the principal-agent relationship is affected.
Pros & Cons Of Agency Theory
Here are some common advantages and disadvantages of the agency theory –
- Thanks to the agency theory, it is possible to resolve lots of differences and disputes between the agents and the principals.
- The incentives motivate the agents, which reduces the losses of the agencies or the farm.
- Compensating agents based on their performances can help cut agency losses.
- With more transparency between the agents and the principals, there remains less room for conflicts of interest.
- One of many drawbacks of the agency theory lies in its theoretical focus on the agent-principal relationship. The theory ignores a vast spectrum of human intentions by emphasizing solely opportunistic and self-interested behavior.
- In the case of a shareholder-executive relationship, an approach based on shareholder’s interest can limit the use of strategic choices and collective activities.
- Many have criticized the theory for the oversimplification of organizational conflicts. Also, its emphasis on the need for mathematical complexity to identify agency problems and solve them is also criticized.
Going through the relationship types under agency theory gives you a tour of the real-world implementation of this theory. It has its merits and drawbacks, but the theory helps understand and identify different issues within an organization. It uses the principal’s interest as the base and identifies the agent’s incapability or unwillingness to carry out. Hence, a conflict of interest arises.