Agency theory is a principle used to explain and resolve issues in the relationship between business principals and their agents. It is a concept used to explain the important relationships between principals and their relative agents. In the most basic sense, the principal is someone who heavily relies on an agent to execute specific financial decisions and transactions that can result in fluctuating outcomes. An agency, in broad terms, is any relationship between two parties in which one, the agent, represents the other, the principal, in day-to-day transactions.
The difference in priorities and interests between agents and principals is known as the principal-agent problem. Agency theory addresses disputes that arise primarily in two key areas: a difference in goals or a difference in risk aversion. For example, company executives, with an eye toward short-term profitability and elevated compensation, may desire to expand a business into new, high-risk markets. However, this could pose an unjustified risk to shareholders, who are most concerned with the long-term growth of earnings and share price appreciation.
Various proponents of agency theory have proposed ways to resolve disputes between agents and principals. This is termed "reducing agency costs". The agency theory explains how to best organize agency relationships so as to prevent conflicts and other issues that arise between agents and principals. There are two key assumptions underlying the agency theory: individuals are generally egoists who act in their own self-interests, and agents have access to more information and are usually in a decision-making capacity.
In summary, agency theory is a principle used to explain and resolve issues in the relationship between business principals and their agents. It addresses disputes that arise primarily in two key areas: a difference in goals or a difference in risk aversion. The agency theory explains how to best organize agency relationships so as to prevent conflicts and other issues that arise between agents and principals.
