What is Agency Theory?




Ans.    A firm or company can be defined in different ways from the point of view of economics, law and sociology.

The legal definition states that a company is a nexus of contracts. A company is actually a group of connected stakeholders, with each having its own interest and views the company differently.

As there is separation of ownership and control, the shareholders appoint Board of Directors to manage the business on their behalf giving rise to the Principal- Agent relationship between shareholders and Board of Directors.

Meaning of Agency Theory :

Michael Jenson and William Meckling (1976) said there exist an agency relationship between owner and management as they believed that a Firm/Company is a nexus of contracts. A company is a network of relationship between different interest groups who have stake in the company. The different stakeholders could be shareholders, managers, creditors, etc. and the often have conflict of interests with others. In a company there is a contractual relationship between the owners .i.e. the ‘Principals’ and the managers, the agents, the Principals (owners) appoint the agents (managers) to perform certain services on their behalf and delegate adequate decision-making authority to the agents. However, often, if the interest of both these groups are not aligned, it creates conflict of interest. The agency theory states that there will be some sort of mistrust between owners and managers. Thus as per this theory, a company (firm) in basically a unit of conflicts rather than a unitary profit seeking machine. It focuses on the relationships and goal incongruous between owners and managers. If there is theory suggest that agent (managers) have tendency to appropriate from the company, because the benefits are higher than the costs as, such costs are shared by various stakeholders.

Agency Theory and Corporate Governance :

The essence of corporate governance in the context of Agency theory is to ensure proper disclosure norms, proper monitory mechanism and others system to ensure there is proper alignment of objectives principals and agents as far as possible, thereby reducing agency costs.

Thus under the agency theory, corporate governance would entail:

1.      Fair and accurate financial and disclosure : Disclosure of financial as well as non financial ensures transparency and reduces incidents of mismanagement or frauds. Beside this, the quality and frequency of disclosures also enhances corporate governance. The statutory auditors should also be independent and professional in this approach while auditing a company.

2.      Independent and Efficient board of directors : To ensure good corporate governance, the board should be made up of who are independent and experts/experts in their line of specialization. The board has fiduciary relationship with shareholders and are accountable to them. Moreover a capable board plays the role of monitoring agency (over managers) thereby reducing conflicts.


Assumption of Agency theory :

According to the agency theory, in an efficient market condition or in a competitive market, corporate governance is already achieves as agency problems will be mitigated. This is because managers will bear costs of its mismanagement and misconduct. Hence it will provide incentives to the agents for self control.

1.      Existence of conflict of interest between owners and managers and between various stakeholders.

2.      Information asymmetry .i.e. managers have or possess all information related business which is normally not easily available to owners and this advantages of information asymmetry is exploited by managers to further their gains.

3.      Agents are opportunists who often engage in activities which serve their self interest. This is possible as owners can not monitor every action of managers due to separation of ownership and management.

4.      Sometimes the agents appointed may not be efficient and capable or at times principal may appoint an agent purely based on his resume without verifying his claims.


Criteria :

1.      The theory only focus on the relationship between shareholders and managers and ignores other stakeholders.

2.      The theory in individualistic in approach that is each individual (group) consider themselves as the only once important in the structure of a company and acts as if it has no meaningful attachments with other groups.

3.      In case of large publicly trade companies, managers are very small fraction of shareholding and hence even if company incurs huge debts, it will not impact them much. Hence it does not deter them from taking risky decision or activities.

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