Question

Question 1

Agency theory is a management and economic theory that attempts to explain relationships and self-interest in business organisations. It describes the relationship between principals/agents and delegation of control. It explains how best to organise relationships in which one party (principal) determines the work and which another party (agent) performs or makes decisions on behalf of the principal (Jensen and Meckling, 1976; Schroeder et al., 2011).

Answer 1

Meaning and importance of Agency theory:

Agency theory is a concept which is used to detail and solve issues in the relationship between the principal and their agent.

Examples of Principal – Agent relationship:

1. Shareholders of the company (as Principals) and the Company executives (as Agents).

2. Owner of the company (as Principal) and the Attorney hired for legal work (as Agents).

Economic theory of agency: Agency theory is also called economic theory and is a part of field contract theory. This theory explains and solves the problems related to principal and agent, which is also known as ‘agency problem’.

Agency problem: The Agency problem arises when the principal and the agent have different interests and the principal is not sure that the agent if acting as per his best interest.

Multiple Principal Problem: In other case, agency problem arises when a scenario comes wherein an agent acts on behalf of multiple principals, which is known as ‘Multiple Principal Problem’, wherein all the principals have to work in the collective interest of the principals and they all have to agree on the agent’s point of view or objectives.

Solution: Various solutions have been provided to solve this issue, out of which a mechanism can be proposed to the management for aligning the interest of the agent with those of the principal. In employment, employer can use commission method, profit sharing method or performance measurement method or posting a bond including a threat of termination of employment to align worker interest with their own.

Principal – Agent Relationship:

Is a relationship which is more of an agency, in which an agent acts on behalf of the principal. And, performs all his tasks with the best interest of the principal without raising any issues of conflicts.

Delegation of Control and challenges:

In certain agency relationships, the principal has to delegate certain controlling powers to the agent for better performance of the task. For example: A principal hires a contractor for construction of a building gives control to do so.

Challenges or Agency Problem:

1. In this instance, principal cannot perfectly and without cost monitor the actions of the agents.

2. It is difficult for the principal to acquire the information possessed by the agent.

Disputes between Principal and Agent:

1. Difference in goals of the principal and the agent.

2. Incompatible levels of risk tolerance.

Best way to organise principal-agent relationship in an organsation is as follows:

1. Performance based compensation: ensuring performance based compensation in an organization can balance out the issues between the principal and the agent.

2. Restricting the agent’s monitory over management activities: this will help management to have independent control over management activities.