What Does the Theory of Agency Emphasize; Provide an Example

Question

Examlex · Accepted Answer

The Answer is The theory of agency, also known as agency theory or the principal-agent problem, emphasizes the relationship and conflicts between principals (owners or shareholders) and agents (managers or executives) in a corporation or any entity where one party is expected to act on behalf of another. The theory is grounded in economics and organizational studies and addresses issues that arise under conditions of partial and asymmetric information, where the agent has more information than the principal.

Agency theory suggests that there is a potential for conflict of interest between the principal and the agent because their goals may not align perfectly. Agents may have the opportunity to act in their own interests rather than in the best interests of the principals. This misalignment can lead to agency costs, which are expenses incurred to prevent agents from straying too far from the interests of the principals. These costs include monitoring expenses, bonding costs (where the agent provides a guarantee of good behavior), and the residual loss (the cost of any divergence from the principal's interest).

An example of agency theory in action is the relationship between shareholders of a public company (the principals) and the company's CEO (the agent). Shareholders want the CEO to make decisions that will increase the value of their shares, while the CEO might be more interested in making decisions that increase their personal wealth or job security, even if those decisions are not in the best interest of the shareholders. To align the CEO's interests with those of the shareholders, the company might offer the CEO performance-based incentives, such as stock options or bonuses tied to the company's financial performance. These incentives are designed to encourage the CEO to make decisions that will benefit the shareholders, thus mitigating the agency problem. However, if not carefully structured, these incentives can also lead to unintended consequences, such as excessive risk-taking or short-termism at the expense of long-term company health.

What Does the Theory of Agency Emphasize; Provide an Example

Definitions: