Agency Theory

What Is Agency Theory?

Agency theory is a principle that focuses on the relationship between principals

and agents. The principal is the superior entity, and they delegate work to the agents. And
agency theory is a concept used to explain and resolve problems in the relationship
between business owners and their agents. The most common relationship is one between
shareholders as principals and company executives as agents. Agency theory is also often
referred to as the “agency dilemma” or the “agency problem.”

Michael C. Jensen and William Meckling popularized the agency theory concept.

In a business scenario, shareholders are the principals, and company executives are
the agents. In a political context, elected representatives are the agents, and their
constituents are the principals. Although it may not seem like it, shareholders and
company executives are tightly connected. Each of their actions greatly affects the position
of one another. And so, the theory points to the conflict of interest and priorities between
principals and agents. Conflict occurs when they are engaged in achieving a specific goal
and agents act on behalf of the principal. Although it may not seem like it, shareholders
and company executives are tightly connected. Each of their actions greatly affects the
position of one another.

What Is the Role of Agency Theory in Corporate Governance?

Agency theory is used to understand the relationships between agents and principals. The
agent represents the principal in a particular business transaction and is expected to
represent the best interests of the principal without regard for self-interest. The different
interests of principals and agents may become a source of conflict, as some agents may not
perfectly act in the principal's best interests.

The principal-agent problem occurs when the interests of a principal and agent come into
conflict.

Corporate governance can be used to change the rules under which the agent operates and
restore the principal's interests. The principal, by employing the agent to represent the
principal's interests, must overcome a lack of information about the agent's performance
of the task. Agents must have incentives encouraging them to act in unison with the
principal's interests.

Agency loss drops when the following situations occur:

 The agent and principal hold similar interests and desire the same outcome.
 The principal is mindful of the agent's activities, so the principal has a keen
knowledge of the level of service they are receiving.

How Does Agency Theory Affect Corporate Governance?

 align the incentives of officers and directors with those of shareholders

 establish norms and customs that prevent the adverse results of divergent
corporate interests;
 affect the duties that officers or director owe to the corporation.

According to researchers, they said that there are also limitations of agency theory.
One limitation is that the theory can be overly simplistic, assuming that shareholders and
managers are rational actors with well-defined objectives. Additionally, the theory does not
take into account other stakeholders, such as employees and customers, who may have a
significant impact on organizational performance. Another limitation is that the theory is
heavily quantitative and may not be able to fully capture the complexity of the
relationships between shareholders and managers.
The limitations of agency theory include:

1. Simplistic assumptions: Agency theory assumes that shareholders and managers are
rational actors with well-defined objectives, which may not always be the case in
real-world organizations.
2. Neglect of other stakeholders: The theory does not take into account other
stakeholders, such as employees and customers, who may have a significant impact
on organizational performance.
3. Over-reliance on quantitative methods: The theory is heavily quantitative and may
not be able to fully capture the complexity of the relationships between
shareholders and managers.
4. Limited attention to culture and norms: Agency theory does not provide a framework
for analyzing the impact of culture and norms on the relationships between
shareholders and managers.
5. Limited attention to the role of institutions: Agency theory does not provide a
framework for analyzing the role of institutions, such as laws and regulations, in
shaping the relationships between shareholders and managers.
6. Limited attention to the role of emotions: Agency theory does not provide a
framework for analyzing the role of emotions in shaping the relationships between
shareholders and managers.
7. Limited attention to the dynamic nature of the relationships: Agency theory does not
provide a framework for analyzing the dynamic nature of the relationships between
shareholders and managers over time.
8. Limited attention to the impact of technology: Agency theory does not provide a
framework for analyzing the impact of technology on the relationships between
shareholders and managers.

Also, in the types of agency theory they categorize it as it can be a positivist and principal
agency theory:

 Positivist, studies have concentrated on defining scenarios in which the principal

and agent are likely to have divergent aims and then detailing the governance
frameworks that restrict the agent’s self-serving or self-interest conduct. For
example, the agent is more likely to operate in the principal’s best interests when
the agreement between the principal and agent is outcome-based, or the principal
has information to verify the agent’s actions.
 The principal-agent researchers focus on the principal-agent relationship and
interaction to create the ideal contract between the principal and the agent. Also, a
behavior-based contract is the most effective since the principal purchases the
agent’s conduct in this situation. Also, because the agent is thought to be more risk-
 averse than the principal, an outcome-based contract would unduly pass the risk to
the agent.

History of Principal Agent Theory

The agency theory developed by Jensen and Meckling (1976), which describes the
connection between management as an agent and shareholders as principals, is the
foundation of this research, where the relationship between the two creates differences of
interest that lead to conflicts or known as conflicts of interest. This conflict will create
pressure on the company's management to improve the company's performance.

Types Of Agency Theory Relationship

Some of the important types are:

1. Shareholders and Company Executives

In this relationship, the company executives serve as the agents and the shareholders as
the principal. Investors, in this case, are the shareholders who fund the companies run by
company executives. Furthermore, the actions taken by the company’s management will
determine the potential impact on the investment. Therefore, the firm management must
make wise decisions.

2. Board of Directors and CEO

The CEO (agent) serves the board of directors (principal). The board of directors would
support the CEO if he can make profitable decisions. On the other side, the relationship
between the board of directors and the CEO might be problematic if the choice made by
the CEO hurts the company’s financial situation.

3. Investor and Fund Manager

The fund manager is the agent, while the investor is the principal. The investor gives the
fund manager a fee, a percentage of the fund’s average assets under management (AUM).
In this scenario, the fund manager allocates the money per the investor’s preferences. If
the fund manager can assist the investors in gaining profits above average, they can
develop a close relationship. Alternatively, if the fund manager reports a loss or profits
lower than expected, the relationship between the investor and the fund manager would
be affected.
Examples

Let us look at the agency theory examples to understand the concept better:

Example #1

Employees are agents, while employers are the principals in agency theory. Employees are
hired in a company to work toward the organization’s goals. However, the increasing
number of corporate scams affects employer and employee relationships. Employees
violate the organization’s ethics, which results in significant financial and reputational
damage. Sometimes the damage done by corrupt employees is irreversible, and an
organization ultimately has to wind up the business.

Example #2

The way a country’s government functions is among the most prevalent examples of
agency theory. The people choose political representatives to govern the nation in a way
that best serves their interests. Representatives of various political parties promise voters
that they will bring reforms in line with the interests of the country’s citizens. However,
voters feel deceived when their elected officials do not fulfill guaranteed promises. Here,
the electorate serves as the principal and chooses the public servants as their agents.

Advantages & Disadvantages

Let us look at several advantages and disadvantages of the agency theory in corporate
governance:

Advantages

 It resolves the disputes between the agents and the principals

 The incentives motivate the agents, reducing losses to the firm or the organization.
 Another strategy to cut agency loss is compensating agents according to
performance.
 Conflict is less likely to arise if there is transparency between the principals and the
agents.

Disadvantages

 Its limited behavioral presumptions and theoretical focus are one of its drawbacks.
A larger spectrum of human motivations is ignored by agency theory since it
primarily emphasizes self-interested and opportunistic human behavior.
  Procedures defending shareholders’ interests may interfere with implementing
strategic choices and limit collective activities. Hence, control mechanisms
recommended based on agency theory are not only expensive but also
commercially unsuccessful.
 The theory has been criticized for oversimplifying organizational conflict and for
the mathematical complexity necessary to find answers to the agency problem

What Is The Principal-Agent Problem?

The principal-agent problem showcases the conflict of priorities between two parties: a
principal and their agent. The principal owns certain assets and hires an agent to make
decisions on behalf of them. Conflicts arise when the agent starts to act in their own best

interests instead of acting in the interests of their clients.

 The principal-agent problem occurs when the principal hires an agent to work in
their best interests, but the latter decides to act in their own self-interest,
challenging the client.
 It can cause monetary losses for the client along with operational challenges, and
market failures, and diminish the trust between the two parties.
  A real-life example can include CEOs or insurance agents catering to their own
interests instead of the shareholders or clients.

Solutions to this problem include structuring a strong contract, incentives, and penalties
through performance analysis and reducing the information gap.

Causes

The person hiring the agent does not know whether this person will work on their behalf
or not. But supposedly, they trust them. However, they are neither aware of the field or
agent nor do they possess the degree of information the agent does. It makes it difficult for
them to determine if the solutions and strategies implemented are in their best interest to
them. As a result, the principal depends on the agent by making a leap of faith.

Effects

The principal-agent problem definition is better understood when the effects are studied
well. Here, the principal inevitably faces some challenges due to the acts of self-interest by
the agent. It can be monetary losses or operational challenges for the firm. The principal-
agent problem in corporate governance can also cause a market failure, which is the
faulty allocation of resources. Instead of using their resources most profitably, the principal
will lose some of it by hiring a service that won’t provide what is needed.

Causes of Agency Problems

 When a conflict of interest arises between the principal and the agent
 When the agent is making decisions on behalf of the principal that is not in the best
interest of each associated party
 The agent may act independently from the principal in order to obtain some sort of
previously agreed upon incentive or bonus
 Confidentiality breach regarding the personal and financial information of the
principal
 Insider trading with the information provided by the principal
 When the principal acts against the recommendations provided by the agent.
Reducing Agency Problems

1. Transparency

To reduce the potential influx of agency problems, it is crucial for both the principal and
the agent to be completely transparent with one another.

Decisions and transactions that will be implemented must be agreed upon by each party
and must be reasonably fair.

Once transparency is present, conflict is reduced due to the fact that there is less confusion
on decision-making and fewer implications that one party is against the other.

2. Restrictions

Imposing restrictions or abolishing negative restrictions is a good way to significantly

reduce the effect of agency loss.

Setting specific restrictions on factors such as agency power allows the principal to feel
more confident in their relative agent.

Conversely, abolishing negative restrictions is beneficial because it instills trust within the
agent and allows them to make decisions freely on behalf of the principal.

3. Bonuses

Introducing and eradicating incentives and bonuses lessens the chances of a relationship
that consists of conflicts and disagreements.
Introducing bonuses is a good way to motivate an agent and will allow them to make
decisions with the best intentions of the principal in order to achieve their desired
incentive.

Contrarily, bonuses may motivate the agent to make decisions just for financial gain,
disregarding the best intentions of the principal to only achieve the incentive.

Each relationship between a principal and agent is different, it is crucial to choose the
best-fitted methods for each specific situation to ensure a positive, healthy relationship.

How Does Agency Theory Affect Corporate Governance?

 align the incentives of officers and directors with those of shareholders

 establish norms and customs that prevent the adverse results of divergent
corporate interests;
 affect the duties that officers or director owe to the corporation.

https://blog.ipleaders.in/agency-theory-of-corporate-governance/

https://www.slideshare.net/shivamgupta714/agency-theory-81515140

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