Agency Theory: Relationships of Principals & Agents

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  • 0:03 What Is Agency Theory?
  • 1:26 History and Characteristics
  • 2:33 Self-Interested Behavior
  • 3:45 Difference in Attitude
  • 4:59 Case Study
  • 5:42 Lesson Summary
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Lesson Transcript
Instructor: Savannah Samoszuk

Savannah has over eight years of hotel management experience and has a master's degree in leadership.

Have you ever hired someone to take care of something you did not have time to do? This is an example of agency theory. This lesson explains the concept of agency, agency theory, the history and characteristics of agency theory, and the common problems with agency relationships.

What Is Agency Theory?

Jim uses a financial advisor to take care of his investing and savings accounts because he does not have time to manage his finances. Jim's advisor acts and makes decisions on Jim's behalf when it comes to his finances. While Jim gives the financial advisor permission to make decisions, the two of them may have different mindsets when it comes to risk, and they may both have different ideas about what kind of gain is the best. This is a great example of agency theory.

Agency relationships exist between principals and agents. Principals are people in positions of authority in a business, whereas agents are people who handle business for others. For example, in the earlier example, Jim is the principal and he hires the advisor as his agent. In this case, Jim is higher in authority because he is employing the financial advisor to take care of his finances for him.

Agency theory is the explanation of the dynamics that occur in these relationships and especially offers an explanation for what happens when there is a problem or conflict in goals that arises between the principal and the agent. The difference in opinion when it comes to risk between Jim and his financial advisor can cause conflict just like that explained by agency theory. This lesson will discuss the characteristics of agency theory, problems with agency theory, and provide a more detailed example of agency theory.

History & Characteristics

Agency theory formally came about in the 1970s, but its concepts have been seen throughout history. For example, for as long as people have done business with one another, the core components of agency theory and the types of conflicts it explains have existed. When farms first started selling their food to grocery stores, it created an agency relationship. When people started organizing financial life into institutions like banks and investment firms, this also created a new type of principal-agent relationship. Agency theory exists when an agency relationship is formed and conflicts or differences in opinion can arise in this relationship.

Agency theory looks at the problems that can arise in any kind of agency relationship with principals and agents. Another example of an agency relationship is that of the relationship between stockholders and the CEO of a company. The stockholder is the principal who effectively hires the CEO to make decisions on their behalf. The core problems that can arise in this relationship are self-interested behavior and difference in attitude in regards to business decisions.

Self-Interested Behavior

When you are trusting someone to handle your finances or business affairs, there can be conflict when it comes to self-interested behavior, or the agent putting his or her own interests before those of the principal. If the agent you hired to run your company or handle your finances only cares about their own self-interest, it can cause problems for you as the person who hired them. Agency theory examines this conflict between these principals and agents.

For example, if Jim's financial advisor is only looking to grow his own bank account, he will not have Jim's best interest in mind, and this is an example of self-interested behavior. Perhaps he will sell an expensive investment package that offers a good bonus or commission, but it will actually result in worse financial outcomes for Jim. This is a classic example of self-interested behavior. In the example of the CEO and stockholders' relationship, the CEO may have his own interest (perhaps making decisions that benefit the CEO's position more than the company's bottom line) in mind when making decisions for the business. This type of self-interested action can occur in nearly all principal-agent relationships.

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