The Agency Problem in Finance: Definition & Examples

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  • 0:00 The Best Interests of…
  • 0:46 What Is the Agency Problem?
  • 1:56 Real Life Examples
  • 2:53 Lesson Summary
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Lesson Transcript
Instructor: Brianna Whiting
The agency problem can be a really big issue in the finance world. Find out what an agency problem is and look at some real-world examples. Then, test yourself on your new knowledge.

The Best Interests of the Stockholders

Meet Sue. Sue was recently informed that her mother left her a huge inheritance. Not knowing what to do with her new found wealth, Sue's first instinct was to look at ways to invest her money. After countless weeks of researching and speaking to financial advisors, Sue decided to purchase stock in a company called Fun Futons. Because Sue works a full time job, she relies on the management team of Fun Futons to work in the best interest of her money.

However, not long after her initial investment, there arose a conflict between management and many of the stockholders. You see, the managers were no longer working in the best interest of the stockholders, but rather they began working in their own best interest. This conflict is what we call an agency problem.

What Is the Agency Problem?

In general, an agency problem in finance usually happens when an agency (the management of a financial company) does not work in the best interests of the stockholders, (the investors).

You see, because management is hired as the agent for stockholders, it's supposed to make decisions that will benefit stockholders, which in most cases is to maximize the stockholders' wealth. However, when a manager decides to work in his own best interest instead, an agency problem occurs. Sometimes this happens when the agency, or management, encounters costs or a conflict of interest. The agency might then ignore what is best for the stockholders and do what is best for the agency instead.

Like most working individuals, managers want to maximize their own wealth, but this causes conflict between managers and stockholders. So, in order to minimize these types of conflicts, often times, managers are encouraged to work in the best interest of stockholders via incentives. Incentives can be in the form of money, threats of being fired, or by direct influence of stockholders themselves, which can be anything from hiring their own managers to becoming directly involved.

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