Agency Theory

Agency theory explains the relationship between principals (those who delegate authority) and agents (those who act on the principals’ behalf). It addresses how to manage this relationship, the conflicts that can arise when interests diverge, and mechanisms to reduce those conflicts.

Key takeaways

• Principals delegate decision-making authority to agents; differing goals create the principal–agent problem.
• Conflicts can arise from differing risk tolerance, information asymmetry, or self‑interested behavior by agents.
• Agency loss measures the gap between the principal’s optimal outcome and the result produced by the agent.
• Common mitigation tools include incentive alignment, monitoring, transparency, and contractual safeguards.

The principal–agent problem

When a principal assigns decision-making power to an agent, the principal relies on the agent to act in the principal’s best interest. Agency theory assumes these interests may not always align. The principal–agent problem refers to the resulting conflicts, often driven by:
* information asymmetry (the agent has more or better information about actions taken), and
* differing objectives or risk preferences.

Examples of principal–agent relationships include shareholders and corporate management, clients and financial advisors, lessors and lessees, or homebuyers and realtors.

Areas of dispute

Disputes commonly arise when:
* Agents take risks the principal would not accept (e.g., executives pursuing aggressive growth that threatens long-term shareholder value).
Agents underinvest in protecting or maintaining assets entrusted to them (e.g., a lessee who has less incentive than the owner to safeguard property).
Agents prioritize short-term metrics that trigger performance pay, at the expense of long-term results (e.g., manipulating budgets to meet targets).
* Principals lack clear insight into agent performance and must rely on trust or imperfect monitoring, increasing the chance of moral hazard.

Agency loss

Agency loss is the difference between the outcome the principal would achieve if they controlled decisions directly and the outcome produced when the agent acts on their behalf. It quantifies the cost of delegation when agents do not perfectly represent principals’ interests.

In practice, firms try to reduce agency loss by aligning agent incentives with principals’ goals. Common practices include awarding stock options, linking compensation to shareholder returns, and tying bonuses to performance metrics. However, poorly designed incentives can encourage short-termism that harms long-term value.

How to reduce agency loss

Agency loss is minimized when principals and agents have aligned interests, similar risk preferences, and when principals have visibility into agent behavior. Effective measures include:
* Incentive alignment: equity-based pay, performance bonuses tied to long-term metrics.
Monitoring and reporting: audits, independent boards, regular performance reviews.
Contracts and covenants: clear performance standards, clawback provisions, penalties for misconduct.
Transparency and information sharing: better reporting and communication to reduce information asymmetry.
Ownership or co‑investment: giving agents a stake in outcomes to align interests.

Examples

• Realtor and homebuyer: a buyer may worry the realtor favors higher-commission listings over the buyer’s preferences.
• Shareholders and managers: management might pursue risky expansion that benefits managers (e.g., empire building) but not shareholders.
• Lessee and lessor: a lessee may be less motivated than the owner to protect leased assets.

Risk differences between principal and agent

Agents typically make decisions using the principal’s resources; as a result, agents often bear less financial risk than principals. For example, a financial advisor (agent) manages a client’s (principal’s) money—if investments lose value, the client bears the loss while the advisor may not. This asymmetry can encourage agents to take actions that increase principal exposure to risk.

Conclusion

Agency theory frames the challenges of delegation—how to ensure agents act in principals’ best interests despite differing incentives and information. Understanding these dynamics and applying appropriate governance, incentive design, and monitoring reduces agency loss and helps align outcomes with principals’ goals.

Further reading

• Eisenhardt, K. M. (1989). “Agency Theory: An Assessment and Review.” Academy of Management Review.
• Lupia, A. “Delegation of Power: Agency Theory,” International Encyclopedia of the Social and Behavioral Sciences.