The agency theory discusses how to set up agency relationships in a way that minimizes the likelihood of disputes and other problems arising between agents and principals.
What Is the Agency Theory?
Principals and agents are dependent on one another. Therefore, one party’s behavior can have an impact on another. Agency theory advises the best methods to manage corporate interactions to reduce the likelihood of escalating disputes between the parties.
How Does Agency Theory Work in a Business Environment?
Here are a few instances of how agency theory functions in business interactions.
Directors and Stockholders
Shareholders (owners of a company) cannot operate the company as there is a need for efficient and experienced staff to boost productivity. Therefore, they assign this duty to a chosen manager(s). In this case, the shareholders serve as principals and the management team as agents.
Since this allows a division between ownership and control, conflicts between management and shareholders do occur. It is possible that the management is prioritizing its own interests over that of the shareholders.
The agency theory enters the picture here. It states that all of the agents’ acts must be directed at advancing the shareholders’ self-interest.
Fund Managers and Investors
A fund’s principals are its investors, while its managers serve as its agents. Fund managers could put their own interests—like earning big commissions—ahead of the interests of investors.
When agency theory is used, it is necessary for fund managers to behave in the investors’ best interests while receiving a fair remuneration.
Employers and Workers
The connection between an employer and an employee is quite similar to everything mentioned above. Employees are expected to behave in the employer’s best interests, while employers are expected to make sure they are fairly paid.
How to Solve Agency Problem?
The agency theory in an organizational setting pertains to how the company can encourage or inspire its agents (which may include its workers) to act in the organization’s best interest rather than their own self-interest.
Use clear language and instructions in a contract for external agents, like consultants and contractors, to get around the agency problem. You should be really clear about the extent and limitations of the agent’s power, and you may align your interests by tying the agent’s degree of remuneration to the achievement of particular tasks or outcomes.