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Agency Theory

Agency theory is an important area of study for both managers and investors, seeking to discover the “best” way to create, maintain and monitor relationships between the agent and the principal. It is an approach used to explain and solve disputes between principals and their agents concerning the respective priorities. Principals are those who rely upon agents to execute certain transactions, while agents act on behalf of principals. In many situations, they have different priorities and interests and the goal of agency theory is to successfully reconcile those differences.

The agency problem arises when agents, motivated by their own self-interest, take actions that are contrary to the wishes of the principal. Principals seek to reduce this conflict by minimizing or eliminating the negative consequences of the problem, which is known as “reducing agency loss.” This entails better alignment of interests between principals and agents, and better communication and feedback.

The principal has several available means to reduce agency costs and improve the relationship. These include performance-based compensation, alignment of incentives, restriction of information disclosure and monitoring. Performance-based compensation is one of the most commonly used methods for reducing agency losses. If used correctly, this type of compensation can help ensure that the agents’ interests are aligned with those of the firm’s owners.

Principals and agents can be found in many different contexts, such as shareholders and management, financial advisors and their clients, and lessees and lessors. As well as business relationships, agency theory has been used to explore psychological relationships, such as between therapist and patient, or parent and child.

Agency theory provides a useful framework to analyze the incentives, roles and responsibilities of principals and agents, and is an important consideration for any firm or individual engaging in any sort of contract. Its concepts are widely used in areas such as financial analysis, accounting, corporate governance and business ethics. It is also used to measure performance and analyze the capability of managers and employees.

Through the study and application of agency theory principles, principals can ensure that agents will take actions that are of maximum benefit to the corporation. The overall goal is to create an environment of trust and harmonious working relationships between all parties in the contracts. It is imperative for any business that hires agents to maintain fairness and balance in the relationship so both parties receive the desired returns.

Glossary Index