A:

Agency problems—also known as principal-agent problems or asymmetric information-driven conflicts of interest—are inherent in static corporate structures. This conflict arises when separate parties in a business relationship, such as a corporation's managers and shareholders, or principals and agents, have disparate interests. Principals hire agents to represent principals' interests. Agents, working as employees, are assumed and obligated to serve the principal's best interests. Problems occur when the agent begins serving different interests, such as the agent's own interests. Thus, conflict occurs between the interests of principals and agents when each party has different motivations, or incentives exist that place the two parties at odds with each other.

Corporations employ several dynamic techniques to circumvent static issues resulting from agency problems, including monitoring, contractual incentives, soliciting the aid of third parties or relying on other price system mechanisms. The study of agency problems is ongoing in both corporate and academic circles. Increasingly, contract design limits are recognized and corporations are turning to different incentive mechanisms.

Incentivizing Employees

If agents are acting in accordance with their own interests, changing incentives to redirect these interests may be beneficial for principals. For example, establishing incentives for achieving sales quotas may result in more salespeople reaching daily sales goals. If the only incentive available to salespeople is hourly pay, employees may have an incentive discouraging sales. Creating incentives that encourage hard work on projects benefiting the company generally encourages more employees to act in the business's best interest. By aligning agent and principal goals, agency theory attempts to bridge the divide between employees and employers created by the principal-agent problem.

Standard Principal-Agent Models

Financial theorists, corporate analysts and economists often use principal-agent models to study and offer solutions for problems that result from conflicts of interest in business arrangements. These models are constructed to spot and minimize costs.

An agency relationship exists whenever one party's actions affect his own welfare and the welfare of another party in a contractual relationship. Most agency experts attempt to design contracts that can align the incentives of each party in a more efficient manner. Traditionally, such contracts result in unintended consequences, such as moral hazard or adverse selection. (For related reading, see: What is the difference between moral hazard and adverse selection?)

Principal-agent models form the basis of agency theory. Agency theory states that labor and knowledge are imperfectly distributed (asymmetrical) and that additional measures are necessary to correct these distributive inefficiencies.

Agency Theory

Agency theorists have always assumed a large role for explicit incentive mechanisms, such as written contracts and monitoring, to mitigate agency problems. History demonstrates that these solutions are incomplete based on moral hazard and adverse selection.

Principal-agent problems contain elements of game theory, the theory of the firm and legal theory. For example, game theory demonstrates limits for otherwise rational self-enforcement mechanisms. Economist Ronald Coase argued as early as 1937 that market price mechanisms are suppressed by transaction costs inherent in hierarchical corporate structure.

Through the years, several different corporate-specific mechanisms have been identified as possible solutions through agency theory. For example, in 2013, Apple began requiring senior executive employees and board of directors members to own stock in the company. This move was intended to align executive interests with those of shareholders. Management, in theory, no longer benefits from actions that harm shareholders as the significant investment owned by executives forces them to view their own interests as being identical to investor interests. Executives, hired by shareholders to represent the best interests of the company and therefore the best interests of investors, must pay attention to issues impacting the company's health and long-term growth. Apple believes this effort to address the principal-agent problem can improve profitability for investors and keep the company competitive for the future.

Market for Corporate Control

The most frequent example of market discipline for corporate managers is the hostile takeover; bad managers damage shareholders by failing to realize a corporation's potential value, providing an incentive for better management to take over and improve operations.

System of Reputations

A powerful force in every voluntary market, the reputation mechanism provides an incentive for coordinating the actions of parties with limited information and trust. There are dozens of examples of reputation-based associations, the most broad of which is classified as corporate culture.

Other examples include the Better Business Bureau, Underwriters Laboratories, consumer unions, watch groups and other consumer agencies that reinforce reputation constraints.

Economic Calculation and Competition

Ultimately, individual corporate management is disciplined by other competitive managers. All management competes for shareholder equity, and shareholders who feel the loss of mismanagement have an incentive to switch ownership toward better management.

Agency theory has only recently come to recognize the role of dynamic capital and money markets in solving agency problems. Inefficiencies in corporate operations create a form of arbitrage opportunity for entrepreneurs, through reputation-creating organizations or takeovers, to move capital toward better management.

RELATED FAQS
  1. What is the role of agency theory in corporate governance?

    Understand how businesses use agency theory in corporate governance. Learn how moral hazard problems may be addressed using ... Read Answer >>
  2. What does "agency cost of debt" mean?

    Agency cost of debt is an increase in debt costs as shareholder and management interests diverge. Find out why restrictions ... Read Answer >>
  3. What is the difference between a principle agent problem and moral hazard?

    Learn how a principal-agent problem often leads to moral hazards in the context of an agent and principal having different ... Read Answer >>
  4. What are the responsibilities of the principal in a company?

    Learn what a principal is as it relates to business management, and the differences between all the meanings. Find out what ... Read Answer >>
  5. Who is responsible for protecting and managing shareholders' interests?

    Several parties are supposed to be responsible for protecting and managing shareholders' interests, including the company's ... Read Answer >>
  6. What are some of the major regulatory agencies responsible for overseeing financial ...

    Discover the specific responsibilities of some of the major regulatory agencies that oversee financial institutions in the ... Read Answer >>
Related Articles
  1. Managing Wealth

    Agency Theory

    An agency relationship exists when one person -- called a principal -- hires another person -- the agent -- to act on his behalf. Agency theory is concerned with resolving problems that develop ...
  2. Investing

    Evaluating A Company's Management

    Financial statements don't tell you everything about a company's health. Investigate the management behind the numbers!
  3. Investing

    Why You Shouldn't Trust Ratings From Rating Agencies

    When the U.S. debt was downgraded, what does that really mean?
  4. Investing

    Nobel Winners Are Economic Prizes

    Before you try to profit from their theories, you should learn about the creators themselves.
  5. Investing

    Interest Rate Predictions With Expectations Theory

    The expectations theory uses long-term interest rates to predict future short-term interest rates.
  6. Managing Wealth

    Encouraging Good Habits With An Incentive Trust

    Money can be a powerful motivator - why not use it to teach your heirs positive lessons?
  7. Investing

    5 Ways To Save On Real Estate Fees

    Even a 1% reduction in real estate commissions can save you thousands of dollars.
  8. Insurance

    What Your Life Insurance Agent Makes – On You

    Being paid by commission gives life insurance agents an incentive to sell bigger policies and specialized financial products. Remember that before you buy.
  9. Small Business

    Whom Should Corporations Please?

    Companies balance the interests of owners, customers and employees. Find out who comes out on top.
RELATED TERMS
  1. Principal-Agent Problem

    The principal-agent problem occurs when a principal creates an ...
  2. Principal-Agent Relationship

    The principal-agent relationship refers to an arrangement in ...
  3. Agency Costs

    Agency Costs are a type of internal cost that arises from, or ...
  4. Agency Theory

    The agency theory is a supposition that explains the relationship ...
  5. Agency Cost of Debt

    Agency cost of debt is a problem arising from the conflict of ...
  6. Contract Theory

    Contract theory is the study of how individuals and businesses ...
Hot Definitions
  1. Socially Responsible Investment - SRI

    Socially responsible investing looks for investments that are considered socially conscious because of the nature of the ...
  2. Business Cycle

    The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles ...
  3. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  4. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  5. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  6. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
Trading Center