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What is Agency Theory in Business?

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Last editedJan 20212 min read

The agency theory offers a solution to problems arising where there's a clash of interest between a principal and an agent. It however requires that one party concedes for the other. Keep reading to learn more about the agency theory and how it applies in business.

Understanding the Agency Theory

An agency refers to a relationship comprising two parties, where one party, called the agent, represents the other party, called the principal. An agent is usually hired by the principal to perform an act or service on his behalf. By implication, the agent doesn't only use the principal's resources, but also makes decisions with the resulting risks to be borne by the principal alone.

This makes agency relationships complicated as disputes, disagreements and conflicts of interests do arise. When the aspirations of the principal and the agent don’t align, we have a principal-agent problem. This informs the need for a concept like agency theory to regulate how an agency works.

The agency theory explains how to best organize agency relationships so as to prevent conflicts and other issues that arise between agents and principals. There are two key assumptions underlying the agency theory, and they are:

Individuals are generally egoists who act in their own self-interests. In short, both the principal and agent are out for their own benefits.
Agents have access to more information and are usually in a decision-making capacity.

As a result of the above, we see that conflicts result from clash of interests or from the information gaps between the principals and agents. To resolve these, the agency theory requires that the interests of the principal should be seen as paramount while the agent is sufficiently compensated. It primarily addresses disputes arising in two areas; first, where the principal and agents pursue different, unaligned goals, and secondly, where there's a difference in risk aversion, caused by varied risk tolerance capacities

Agency Theory Examples

Below are some examples of how agency theory works in business relationships.

Company Management and Shareholders

There's no doubt that the shareholders of a company are the owners of that company. But for sake of efficiency and the need for experienced hands, the shareholders cannot all run the business at the same time. So they delegate this responsibility to an appointed manager. Here the shareholders are the principals, and the company management are agents.

In essence, there has been a separation between ownership and control. As a result, conflicts do arise between management and shareholders. The management may be pursuing its own goals and aspirations at the expense of the shareholders.

This is where agency theory comes in. It stipulates that all the actions of the agents should be aimed at promoting the self-interest of the shareholders.

Investors and Fund Managers

Another agency theory example is seen in investor-managers relationship.

Investors in a fund are the principals while the fund managers act as the agents. The fund managers might pursue personal interests, such as large commissions, while sacrificing investor interests.

Agency theory is applied here, requiring that the fund managers act as much as possible, in the best interest of the investors, while there is adequate reward for the fund managers.

Employers and Employees

Quite similar to all of the above is the employer-employee relationship. Employees are to act in the best interest of employers while the employers are to ensure that they are sufficiently compensated.

Strategies to Reduce Agency Loss

Agency loss is the amount a principal claims to have been lost because an agent has acted contrary to his wishes. Reducing agency loss is a significant way to reduce disputes of his nature, and it comes in various forms.

A popular example is by offering incentives to agents such as corporate managers, to optimize their relationship with the principal. This exists where shareholders' short or long term returns determine the compensation of company executives.

Compensating agents based on performance represents another way to reduce agency loss. The last resort, in any case, is to fire the agent.

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