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 resulting miscommunication and disagreement may result in various problems and discord within companies. Incompatible desires may drive a wedge between each stakeholder and cause inefficiencies and financial losses. This leads to the principal-agent problem.
The principal-agent problem occurs when the interests of a principal and agent conflict. Companies should seek to minimize these situations through solid corporate policy. These conflicts present normally ethical individuals with opportunities for moral hazard. Incentives may be used to redirect the behavior of the agent to realign these interests with the principal's concerns.
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 theory may be used to design these incentives appropriately by considering what interests motivate the agent to act. Incentives encouraging the wrong behavior must be removed, and rules discouraging moral hazard must be in place. Understanding the mechanisms that create problems helps businesses develop better corporate policy.
To determine whether or not an agent acts in his or her principal’s best interest, the standard of “Agency Loss” has emerged as a commonly-used metric. Strictly defined, agency loss is the difference between the optimal results for the principal and the consequences of the agent’s behavior. For example, when an agent routinely performs with the principal’s best interest in mind, agency loss is zero. But the further an agent’s actions diverge from the principal’s best interests, the greater the agency loss becomes.
Agency loss drops when the following situations occur:
- The agent and principal both hold similar interests of achieving the identical income.
- The principal is mindful of the agent’s activities, so the principal has a keen knowledge of the level of service he is receiving.
If neither of these events occurs, agency loss is likely to climb. Therefore, the chief challenge involves persuading agents to prioritize their principal’s best interest while placing their self-interest second. If done correctly, the agent will nurture their principal’s wealth, while incidentally enriching their bottom lines.