Agency Theory in Different Business Scenarios

Agency Theory in Different Business Scenarios

In the past, the owners of companies usually used to run their companies themselves. However, as the business activities within a company become increasingly sophisticated, owners of the company find it difficult to deal with all those activities alone. Therefore, managers are hired to help with the management of the entity following owners’ instructions. When not given enough attention by their owners, managers can have a significant influence on the best benefits of companies through choosing operational plans and making strategic decisions. As a consequence, agency theory is introduced to resolve the issues raised by such relationships between company owners (principal) and managers (agent). This essay will firstly explain agency theory, then present its applications in different business scenarios and finally discuss its significance and contributions to society.

Agency theory had not been found until the occurrence of agency relationship. According to Jensen and Meckling (1976), agency theory shows concerns about the disputes raised by principal-agent relationship and provides solutions to the problems derived from this relationship. Agency relationship occurs when one principal or more hire other individuals as their agents whose performance have to represent the benefits of principals. To achieve a good performance, agents have to be given some decision-making authorities by principals. This entrustment of managerial duty by principals and the separation of responsibility held by principals and agents concentrate on boosting a more profitable business. However, Jensen and Meckling (1976) explain that such delegation also means that an agency relationship has to be established based on the trust between principals and agents so that agents could perform in the best interests of principals. Conflicts of interests between both parties such as short-term goals held by the agent as well as long-term goals held by the principal often prevent the agency relationship to be well established. In other words, when agents act differently from what principals desire, the trust between them would be diminished and the distrust would affect the organization’s business operation in the long run.

First introduced by Jensen and Meckling (1976), this theory suggests that principals do not always have reasons to trust their agents because of the conflicting interests held by different parties. As a consequence, principals are willing to search methods for resolving these issues to persuade agents to have the same targets and goals with principals by applying mechanisms in management and reducing the negative effects brought by information asymmetries and opportunistic behavior in business. Specifically, Jensen and Meckling (1976) regard information asymmetry as an economic phenomenon that information is treated as a commodity that can be purchased in business practice and more or better information always requires higher price. Opportunistic behavior is explained as actions that one party does not disclose the information to others due to its desires for taking information advantage.