Question

In your own words explain how agency theory and corporate governance are related. Provide examples of companies that have experienced problems in corporate governanc

Answer 1

Agency theory is used to understand the relationships between agents and principals. The agent represents the principal in a particular business transaction and is expected to represent the best interests of the principal without regard for self-interest. The different interests of principals and agents may become a source of conflict, as some agents may not perfectly act in the principal's best interests. The resulting miscommunication and disagreement may result in various problems and discord within companies. Incompatible desires may drive a wedge between each stakeholder and cause inefficiencies and financial losses. This leads to the principal-agent problem.

The principal-agent problem occurs when the interests of a principal and agent conflict. Companies should seek to minimize these situations through solid corporate policy. These conflicts present normally ethical individuals with opportunities for moral hazard. Incentives may be used to redirect the behavior of the agent to realign these interests with the principal's concerns.

Corporate governance can be used to change the rules under which the agent operates and restore the principal's interests. The principal, by employing the agent to represent the principal's interests, must overcome a lack of information about the agent's performance of the task. Agents must have incentives encouraging them to act in unison with the principal's interests. Agency theory may be used to design these incentives appropriately by considering what interests motivate the agent to act. Incentives encouraging the wrong behavior must be removed, and rules discouraging moral hazard must be in place. Understanding the mechanisms that create problems helps businesses develop better corporate policy.

AGENCY THEORY EXAMPLES

One of the most common examples of agency theory can be seen in the way a government of a country functions. The masses elect political representatives to run the country in a way that maximizes their interests. Representatives of different political parties promise the voters to bring changes in the governing model of the country. However, the electorates of almost all sovereigns find themselves cheated when their elected candidates act in an unscrupulous manner after assuming office. Here, the voters act as principals who elect the government representatives to act as their agents.

Another common example of agency theory is between the employees and employers of an organization. The employees are hired to work in accordance with the objectives of the organization. However, the growing number of corporate scams shows that this relationship is not always taken in a way it is meant to be. The employees work against the ethics of the organization causing it huge financial and reputational damage. Sometimes, the loss caused by such corrupt employees is beyond repair and an organization has to wind up its business altogether.