Type 1 and type 2 agency problem

A concept that explains the important relationships between principals and their relative agent

Agency theory is a concept used to explain the important relationships between principals and their relative agent. 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.

Because the principal relies so heavily on the agent to make the right decision, there may be an assortment of conflicts or disagreements. Agency theory dives into such relationships.

In terms of business, the principal is considered to be a shareholder, while the agent is considered to be a company executive. Although it may not seem like it, shareholders and company executives are tightly connected. Each of their actions greatly affects the position of one another.

Agency theory is also often referred to as the “agency dilemma” or the “agency problem.”

Different Agency Theory Relationships

When it comes to business and the concept of agency theory, there several types of relationships that are closely intertwined and are faced with some sort of disagreement.

Shown below are some of the most in-depth and connected relationships in businesses that involve a principal-agent relationship and qualify for the agency theory.

1. Shareholders and Company Executives

As mentioned, the shareholder is represented by the principal. It is because the shareholder invests in an executive’s business, in which the executive is responsible for making decisions that affect the shareholder’s investment.

If the company executive acts negatively and reduces the worth of the shareholder’s stock, it will spark a disadvantageous relationship.

On the other hand, if the company executive were to act ethically resulting in some sort of financial boost in the shareholder’s stock, a positive connection will form.

2. Investor and Fund Manager

In such a case, the investor is the principal because they are giving a portion of their income to the fund manager to allocate on their behalf.

If the fund manager were to invest in volatile stocks and yield a return less than expected from the investor, a negative relationship begins to form.

Conversely, if the fund manager goes above and beyond and nets a profit outside of the realm of expectation, the investor praises the fund manager and there is a healthy linkage.

3. Board of Directors and CEO

Up in the hierarchy, the board of directors is represented by the principal because their financial position and status are decided by the CEO.

If the CEO were to make a wrong financial decision that put the organization at a deficit, the board of directors is more likely to vote against the CEO in the next election.

Oppositely, if the CEO were to introduce a new business sector that provided unprecedented innovation in the market, they would be praised by the board of directors and would likely stay in power for years to come.

The idea of agency theory is represented by the relationships expressed above.

All of the interactions and disagreements faced by both the principal and agent are what make up the entire exploration of the concept.

Causes of Agency Problems

As mentioned throughout the text, the agency theory explores the distinctive relationship between a principal and their agent. Throughout the relationship, there is a number of actions and decisions that are made by the agent on behalf of the principal.

The same actions and decisions are what generates disagreements and conflict between the two parties. To explain in more depth, listed below are the main causes of agency problems:

• When a conflict of interest arises between the principal and the agent
• When the agent is making decisions on behalf of the principal that is not in the best interest of each associated party
• The agent may act independently from the principal in order to obtain some sort of previously agreed upon incentive or bonus
• Confidentiality breach regarding the personal and financial information of the principal
• Insider trading with the information provided by the principal
• When the principal acts against the recommendations provided by the agent.

Considering there is power/trust allocation, it is not surprising that there is an entire theory that explores the relationship and interactions between a principal and an agent.

Reducing Agency Problems

In order to reduce the likelihood of conflict, there are certain measures and principles that can be followed by both the principal and agent.

1. Transparency

To reduce the potential influx of agency problems, it is crucial for both the principal and the agent to be completely transparent with one another.

Decisions and transactions that will be implemented must be agreed upon by each party and must be reasonably fair.

Once transparency is present, conflict is reduced due to the fact that there is less confusion on decision-making and fewer implications that one party is against the other.

2. Restrictions

Imposing restrictions or abolishing negative restrictions is a good way to significantly reduce the effect of agency loss.

Setting specific restrictions on factors such as agency power allows the principal to feel more confident in their relative agent.

Conversely, abolishing negative restrictions is beneficial because it instills trust within the agent and allows them to make decisions freely on behalf of the principal.

3. Bonuses

Introducing and eradicating incentives and bonuses lessens the chances of a relationship that consists of conflicts and disagreements.

Introducing bonuses is a good way to motivate an agent and will allow them to make decisions with the best intentions of the principal in order to achieve their desired incentive.

Contrarily, bonuses may motivate the agent to make decisions just for financial gain, disregarding the best intentions of the principal to only achieve the incentive.

Each relationship between a principal and agent is different, it is crucial to choose the best-fitted methods for each specific situation to ensure a positive, healthy relationship.

Learn More

Thank you for reading CFI’s guide to Agency Theory. To keep learning and developing your knowledge base, please explore the additional relevant resources below: