Agency theory

Agency theory is a management and economic theory that attempts to explain relationships and self-interest in business organizations. In agency theory, principals contract with agents to perform tasks for the benefit of the principal. In making the CONTRACT with the agent, the principal delegates authority regarding how a task is to be accomplished, holding the agent responsible for attaining a certain outcome but not dictating the methods used to achieve the outcome. Typical principal-agent relationships include shareholder-manager and manager-employee relationships. In a shareholder-manager relationship, the SHAREHOLDERS, through their BOARD OF DIRECTORS, set goals and managers allocate the company’s RESOURCES to attain the goals. As evidenced in the Enron scandal, management’s goals may be in conflict with those of shareholders. In the Enron case, managers manipulated financial arrangements among themselves, profiting significantly but ultimately bankrupting the company and leaving Enron shareholders (and many employees) with nothing. Agency theory suggests that a system is needed to ensure managers operate in the best interests of the principals they represent. As in the Enron case, AUDITING is one agency cost principals incur in order to monitor the activities of managers. Limits placed by shareholders on the options managers can choose, such as private PARTNERSHIPs with executives, and bonus systems are also used to reduce the conflict of purposes between the self-interests of managers and the interests of shareholders. Performance-based pay systems are designed to give agents—whether managers reporting to the board of directors of employees reporting to managers—incentives to work for the best interests of the principals. In many instances, these systems fail to attain the desired goal. MIT management professor Robert Gibbons describes three cases where incentive systems failed. Sales managers frequently face principal-agent conflicts. Straight salary systems would deter actions on the part of sales agents that are in conflict with the goals of the sales manager, but straight salary systems do not give salespeople positive work incentives. Agency theory suggests that businesses operate under conditions of uncertainty and lack of complete information. Given these obstacles, two agency problems arise: the problem of employees not putting forth their maximum effort, referred to as moral hazard; and the problem of agents misrepresenting their ability to do the work for which they are being hired, called adverse selection. As in the situations Gibbons described, tying compensation to performance or profits does not eliminate the problem of conflicting interests between principals and agents. While agency theory illustrates the economic conflicts between groups, few solutions beyond vigilance, on the part of principals, have been proposed.
See also PERFORMANCE APPRAISAL.