Definition:
Agency theory is a framework that examines the relationship between principals and agents. In business, principals are typically the owners or shareholders of a company, while agents are the managers or employees who act on behalf of the principals.
Key concepts of agency theory:
- Principal-agent problem: The principal-agent problem arises when the interests of the principal and agent are not aligned. This can lead to situations where agents may act in their own best interests rather than in the best interests of the principal.
- Agency costs: The costs associated with aligning the interests of principals and agents. These costs can include monitoring costs, bonding costs, and residual loss.
- Incentive contracts: Contracts that are designed to align the interests of principals and agents. These contracts often include performance-based incentives, such as bonuses or stock options.
Why is agency theory important?
- Corporate governance: Agency theory is a key component of corporate governance, as it helps to ensure that managers act in the best interests of shareholders.
- Compensation design: Agency theory is used to design compensation packages that motivate managers to act in the best interests of the company.
- Corporate control: Agency theory can help to explain why some companies have better corporate governance than others.
In essence, agency theory is a framework that helps to understand the relationship between principals and agents and the factors that can influence their behavior.
