Agency theory or principal–agency theory in political science and economics is a theory around agents: a person or entity (the "agent"), who is able to make decisions on behalf of, or that impact, another person or entity: the "principal". The dilemma exists in circumstances where the agent is motivated to act in his own best interests, which are contrary to those of the principal, and is an example of moral hazard.
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- Agency theory argues that in the modern corporation, in which share ownership is widely held, managerial actions depart from those required to maximise shareholder returns (Berle and Means 1932; Pratt and Zeckhauser 1985). In agency theory terms, the owners are principals and the managers are agents and there is an agency loss which is the extent to which returns to the residual claimants, the owners, fall below what they would be if the principals, the owners, exercised direct control of the corporation (Jensen and Meckling 1976). Agency theory specifies mechanisms which reduce agency loss (Eisenhardt 1989). These include incentive schemes for managers which reward them financially for maximising shareholder interests. Such schemes typically include plans whereby senior executives obtain shares, perhaps at a reduced price, thus aligning financial interests of executives with those of shareholders (Jensen and Meckling 1976). Other similar schemes tie executive compensation and levels of benefits to shareholders returns and have part of executive compensation deferred to the future to reward long-run value maximisation of the corporation and deter short-run executive action which harms corporate value.
- Lex Donaldson, and James H. Davis. "Stewardship theory or agency theory: CEO governance and shareholder returns." Australian Journal of management 16.1 (1991): 49-64. p. 50
- Agency theory considers the optimal contract form for that ubiquitous control relationship in which one person, the principal, delegates work to another, the agent... The agency problem is to determine the optimal contract for the agent's service. For example, in our earlier vignette of the minicomputer manufacturer, the manufacturing vice-president is the principal and the plant managers are the agents in an agency model of the vignette. Again, in the case of the vignette, the agency problem is to determine the measurement and reward structures for the plant managers such that they appropriately balance concerns for inventory, service, quality, and cost in a context of uncertain demand.
- The theory is simply stated in terms of two cases. When the behavior of the agent is observed, a behavior based contract is optimal because the agent's behaviors are the purchased commodity. This is the simple case of complete information. Both parties, principal and agent, know what the agent has done. The second case is incomplete information. The agent is aware of his/her behaviors, but the principal is not. A dilemma arises because the principal cannot determine if the agent has behaved appropriately. If the principal rewards the agent based upon the agreed job behaviors, but without confirmation of those behaviors by the principal, the agent may shirk. The agent cannot be relied upon to perform as agreed.
- Kathleen M. Eisenhardt, "Control: Organizational and economic approaches." Management science 31.2 (1985): 134-149.
- Agency theory is an important, yet controversial, theory. This paper reviews agency theory, its contributions to organization theory, and the extant empirical work and develops testable propositions. The conclusions are that agency theory (a) offers unique insight into information systems, outcome uncertainty, incentives, and risk and (b) is an empirically valid perspective, particularly when coupled with complementary perspectives. The principal recommendation is to incorporate an agency perspective in studies of the many problems having a cooperative structure.
- Kathleen M. Eisenhardt, "Agency theory: An assessment and review." Academy of management review 14.1 (1989), p. 57; Article abstract
G - LEdit
- This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the 'separation and control' issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears the costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem.
M - REdit
- As with all theories, we can learn something from agency theory and transaction-costs economics, since they emphasize something others hide. But as with all theories, they also distort; in fact, I will argue that their distortions outweigh the value of what they highlight.
- Charles Perrow (1972), Complex organizations: a critical essay, Glenview, IL: Scott, Foresman, and Company; y (3rd ed.). Random House, 1986. p. 220
- The relationship of agency is one of the oldest and commonest codified codes of social interaction. We will say that an agency relationship has arisen between two (or more) parties when one, designated as the agent, acts for the other, designated the principal, in a particular domain of decision problems. Examples of agency are universal.
- Stephen A. Ross "The Economic Theory of Agency: The Principal's Problem," Amer. Econom. Rev., 63 (1973), 134-139; As cited in Eisenhardt (1985, 136)