Question

At the heart of Agency Theory are the twin issues of Goal Conflict and Risk Sharing. Discuss each of these what each is; why it creates problems; and what can be done to counteract it (only one option is needed).

Answer 1

Meaning of Agency theory-

In simple words its a theory thst attempts to explain and resolve the disputes that rises in the relationship between business principles and their agents it resolves the difference in expectations which is called " reducing agency loss".

The relationship is one between

Shareholders as Principals and

Company executive as Agents

Understanding the theory- it can be understand as a relationship between two parties in which one agent represents the other.the principal hired an agent to perform its day to day transaction or service on its behalf.

In short Principal delegates its decision making authority to agent.difference of opinion,priorities and interest may arise that may result in dispute between the two.

Areas of dispute in Agency Theory

1- Goal conflict

As the name itself clearifies that the dispute arises due to difference in goals or objectives for eg- an executive may decide to expand a business which will sacrifice the short term profits and the conflict arise as shareholders may place priority on short term capital growth.it can occur too when an individual or organisation is involved in multiple interest that may lead to conflict in their ability to act in the best interest of one party.the difference in goal leads to confkict as principal is unsure that the agents are always acting in its best interest,particularly when activities are useful to the principal are costly to the agent and vice versa.moral hazard and conflict of interest or goal arises.

2- Risk sharing

Another problem or issue is risk sharing that is it invoves incompatiable level of risk tolereance between principal and agent.it csn be explained with the help of an example- a shareholder may object the management has set too low on loan approval,thus taking a great risk involvement.

Reducing agency loss

1- offering incentive

The 1st strategy that can be adopted to reduce such loss is the offering incentive to managers to maximize profits of the principals .these incentives optimize the relationship between the two.

2- executive compensation-

Another strategy to reduce loss is tying executive compensation in part to shareholders return.performance based compensation is one eg.in which executive pay is partially deferred and to be determined according to long term goals.

To conclude, tgese two strategies or practices will endanger the long term company growth in order to boost short term profit.this can be seen in budget planning ,where management reduces estimates in budget and meet performance goals.