Agency theory – explanation and examples

Author: Ryan Mutuku | Updated: 16 hours ago

Agency theory is an approach that explains a situation whereby an agent acts on behalf of a principal to contribute to the progress of the principal’s goals. It also describes the conflict of interest or relationship that arises between agents and principals. In an agency business, a principal hires an agent to represent them or work for them.

A conflict of interest can arise when the agent starts to make business decisions that only benefit them and not the principal. For example, stockholders may order the CEO to outsource other projects to reduce costs and keep margins high. The CEO may be unwilling to do so because of the risks involved such as imprecise delivery times or low-quality goods. Read more:

Conflicts in business Another way to define agency theory is in how it tries to resolve the conflicts that occur due to control and separation of ownership between agents and principals. Two conflicts that can arise in such an arrangement include:

1. The agency problem

This problem occurs in two ways:

  • When the goals of the agent and principal contradict.
  • When it is costly or tricky for the principal to confirm what the agent has been doing. The principal is unable to assert that the agent is acting suitably.

2. Risk sharing problem

It occurs when the agent and principal have a different interpretation of risk. Both parties prefer to take different approaches in business because of their different positions on risk.

The focus of agency theory is to determine a valid contract that governs the relationship between the principal and agent. This is due to the presumptions about organizations, people, and information. Organizations have goals that conflict among founders, and people have self-interests. Information is a product that people or organizations can buy.

Generally, the definition of agency theory explains the relationships that depict the basic structure of agents and principals engaged in a common intent, but both have dissenting goals and dissenting approaches to risk.

Agency theory applications

Agency theory has many applications. Scholars have been using it in economics, accounting, finance, organizational behavior, marketing, sociology, and political science. The structure of the principal-agent relationship theory is also applicable in many settings. It can range from issues like regulatory policies to phenomena like blame and manifestations of self-interest.

In most cases, scholars apply agency theory to organizational phenomena like compensation, ownership and finance structures, acquisitions and diversification, and innovation.

The relationship between an agent and principal is deeply rooted in common law. This is whereby principals use employment contracts to employ agents. The contract is the most crucial document in this relationship because it binds both parties. It is also common in contracts that bind employees to carry on specific duties for their employer. Some examples of this include:

  • Enterprises hire managers, employees, and board of directors to act on their behalf.
  • Single-person enterprises can take part in an agency relationship as middlemen. Dealers, insurance agents, lawyers, and brokers are examples of single-person enterprises.
  • Unlimited companies are a network of agency relationships. The relationships can overlap because shareholders are agents of other shareholders.
  • Policemen and physicians become agents that offer services to communities or societies.

Frequently, agents encounter many problems when working for principals. Similarly, principals deal with many different issues mostly to ensure that the actions taken by agents realize their goals.

Examples of Agency Theory

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