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Agency Problem

The agency theory describes the relationship between principals (shareholders) and agents (directors) in a company. Principals delegate control of the company to agents to manage it on their behalf. However, there is an inherent conflict of interest as agents do not always have the same long-term goals as principals. Mechanisms like monitoring, incentives, and rewards are used to try and align the goals of principals and agents. However, agency theory breaks down when monitoring is lax, greed takes over, or there is pressure for short-term gains over long-term growth.

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74 views

Agency Problem

The agency theory describes the relationship between principals (shareholders) and agents (directors) in a company. Principals delegate control of the company to agents to manage it on their behalf. However, there is an inherent conflict of interest as agents do not always have the same long-term goals as principals. Mechanisms like monitoring, incentives, and rewards are used to try and align the goals of principals and agents. However, agency theory breaks down when monitoring is lax, greed takes over, or there is pressure for short-term gains over long-term growth.

Uploaded by

jothi subra
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Principle / Shareholder

Accountable

Carried out on
Behalf of Agent / Directors

Task
Manage Organization
Agency Theory

The most significan feature of the concept of corporate governance is the Agency
theory and its attendant characteristics. From figure above, it can be inferred that a firm
subscribes to various elements as depicted in table… to constitute a system. The
functional direction and control of these elements is facilitaed by the creation of
relationships and responsibilities. This where the source of agency problemin lies in the
firm. The investor or the owner of the firm, assumes the role of principal and employs
agents (directors) to manage the organizational tasks. Due to the complexity of the
organization inevitably evolves the separation of responsibilities between the principal
and agent. The principal assumes ownership of the business and the control of the
business is transferred to the agent.

This where the conflict of interest arises which in turn leads to the misalignment of goals
between the two parties. Generally the principal has a long term vested interest in his
business. However, the agent not being the owner, usually does not have long term
interest and commitment in the firm. Therefore how to reduce the gap of misalignment
between the principal and agent.

In order to ensure that the principal’s goal of maximizing wealth is being realized, the
role of stewardship is given to the agent hoping that the agent will conscientiously
carryout his fiduciary responsibilities. However, this is where the issue lies; what are the
motivational factors that will drive him to realize the principal’s goal.

On the one hand, the agent will be adequately remunerated in accordance with market
standards, given incentives, added with rewards for better performance and other perks
and privileges in accordance with the firm’s profit margin standings. On the contrary,
the principal upon delegating control function to the agent, has a greater task of
determining managerial accountability. In that, he has to maintain a consistent
monitoring and control mechanisms to regulate the behaviour of the agent.

When does the agency theory becomes a disappointment? When the monitoring and
control mechanism is lax, when the business is on a high growth trajectory, returns are
handsome, conversely when there is extreme pressure from the principal for plucking
low hanging fruits etc. Ultimately when the agent is obsessed by greed and voracity to
make fast big bucks. This is when the moral and ethical dimensions of the agent flees
through the backdoor. The agency theory by design has been playing a central role in
the open market economy. In the discussions that follow, we will be able to ascertain
the veracity of agency theory with regards to its implications on corporate governance.

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