HASSOUN Ihsane

ACG

Agency Theory

Agency theory is a principle that is used to explain and resolve issues in the relationship between business
principals and their agents. Most commonly, that relationship is the one between shareholders, as
principals, and company executives, as agents.

KEY TAKEAWAYS

 Agency theory attempts to explain and resolve disputes over priorities between principals and
their agents.

 Principals rely on agents to execute certain transactions, particularly financial, resulting in a

difference in agreement on priorities and methods.

 The difference in priorities and interests between agents and principals is known as the principal-
agent problem.

 Resolving the differences in expectations is called "reducing agency loss."

 Performance-based compensation is one way that is used to achieve a balance between principal
and agent.

 Common principal-agent relationships included in agency theory include shareholders and

management, financial planners and their clients, and lessees and lessors.

Understanding Agency Theory

An agency, in broad terms, is any relationship between two parties in which one, the agent, represents the
other, the principal, in day-to-day transactions. The principal or principals have hired the agent to perform
a service on their behalf.

Principals delegate decision-making authority to agents. Because many decisions that affect the principal
financially are made by the agent, differences of opinion, and even differences in priorities and interests,
can arise. Agency theory assumes that the interests of a principal and an agent are not always in
alignment. This is sometimes referred to as the principal-agent problem.

By definition, an agent is using the resources of a principal. The principal has entrusted money but has
little or no day-to-day input. The agent is the decision-maker but is incurring little or no risk because any
losses will be borne by the principal.

Financial planners and portfolio managers are agents on behalf of their principals and are given
responsibility for the principals' assets. A lessee may be in charge of protecting and safeguarding assets
that do not belong to them. Even though the lessee is tasked with the job of taking care of the assets, the
lessee has less interest in protecting the goods than the actual owners.

Areas of Dispute in Agency Theory

Agency theory addresses disputes that arise primarily in two key areas: A difference in goals or a
difference in risk aversion.

For example, company executives may decide to expand a business into new markets. This will sacrifice
the short-term profitability of the company in the expectation of growth and higher  earnings in the future.
However, shareholders may place a priority on short-term capital growth and oppose the company
decision.

Another central issue often addressed by agency theory involves incompatible levels of risk tolerance
between a principal and an agent. For example, shareholders in a bank may object that management has
set the bar too low on loan approvals, thus taking on too great a risk of defaults.

Transaction cost Williamson

Transaction cost economics is understood as alternative modes of organizing transactions (governance

structures – such as markets, hybrids, firms, and bureaus) that minimize transaction costs
(Williamson 1979). Transaction cost theory (Williamson 1979 , 1986 ) posits that the optimum
organizational structure is one that achieves economic efficiency by minimizing the costs of exchange.
The theory suggests that each type of transaction produces coordination costs of monitoring,
controlling, and managing transactions. Williamson has defined transaction costs broadly as the costs of
running the economic system of firms. He has argued that such costs are to be distinguished from
production costs and that a decision-maker can make a choice to use a firm structure or source from the
market by comparing transaction costs with internal production costs. Thus, cost is the primary
determinant of such a decision.