Agency theory

Definition

Agency theory explains the relationship between principals (e.g., shareholders) and agents (e.g., corporate executives). It focuses on resolving conflicts that arise when agents do not align with the interests of principals.

5 Must Know Facts For Your Next Test

1. Agency theory addresses the principal-agent problem, where there is a conflict of interest between owners and managers.
2. It highlights issues like moral hazard and adverse selection in corporate governance.
3. Monitoring mechanisms, such as performance-based compensation, are used to align agents' actions with principals' interests.
4. The theory suggests that information asymmetry can lead to inefficiencies in decision-making within corporations.
5. Effective board oversight is crucial in mitigating agency problems by ensuring managers act in shareholders' best interests.

Review Questions

• What is the principal-agent problem in the context of agency theory?
• How does information asymmetry affect decision-making according to agency theory?
• What are some mechanisms used to align the interests of managers with those of shareholders?

Related terms

Principal-Agent Problem: A situation where there is a conflict of interest between a principal (owner) and an agent (manager).

Moral Hazard: Occurs when one party takes undue risks because they do not bear the full consequences of their actions.

Information Asymmetry: A condition where one party has more or better information than the other, leading to imbalanced decision-making.