Question

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 organize 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).

Discuss

Answer 1

Agency theory is a theory which explains the relationship between the principal and his agent. It advocates that an agent should carry out the business on the behalf in principal acting as his representative and excercising his power without any conflict of interest.

Principal and agent are guided by different self goals and that could lead to conflict of interest between the two of them. Sometimes agent prioritise his interest before the interest of principal and that could lead to principal agent problem.

There should always a proper contract which illustrates the clear roles of both the parties and how the conflicts are to be resolved in case there is conflict of interest. There should be proper communication channel between both principal and agent and compensation and commision should be properly defined to avoid and resolve any conflict.

The degree of delegation of authority and control must be properly defined between the both parties .The agent should always work in principal's best interest.

One instance From history could be provided as a reference in this regard when Lehman brothers didn't pay heed to the shareholders interest and worked for the fulfillment of self goals by having excessive exposure in risky securitiies.The management took drastic exposure to gain market share and make higher profits without paying any heed towards Shareholders interest which led to blowing up the entire company as well as taking shareholders of Lehman down with it.

So it is always important to keep the interest of shareholders in priority by management and make proper disclosure and decision making which eventually helps the shareholders in the long run.