Agency Theory
| Author | Mary Oliverio |
| Pages | 23-24 |
Page 23
Agency theory pertains to the relationship between two parties; the first is the principal (or principals) and the second, the agent (or agents), who are engaged as employees or independent contractors. Considered a subunit of the theory of contracts, agency theory deals with the determination of the general structure of such contractual relationships and factors that influence behavior of the parties involved.
While the principal/agent relationship was recognized in the writing of early economists, including Adam Smith, the identification of this special aspect of contracts dates to the 1970s. A significant paper published in 1976 by Michael Jensen and William Meckling identified elements from the theory of agency in their consideration of the theory of the firm. They commented:
The firm is a "black box" operated so as to meet the relevant marginal conditions with respect to inputs and outputs, thereby maximizing profits.… Except for a few recent and tentative steps, however, we have no theory which explains how the conflicting objectives of the individual participants are brought into equilibrium so as to yield this results.
The theory has continued to evolve since the Jensen-Meckling paper was written. In noting the basic analyses still to be undertaken, J. Gregory Dees stated in 1992, "principal-agent analysis is a diverse and rapidly developing field.… While commonly referred to as 'agency theory,' … I … believe the label is misleading. It is more accurate to describe it as a modeling approach within which there are some common structure and assumptions with wide variations" (p. 27). Yet, in 2002 Eric Brousseau hinted at the incompleteness of the theory in considering the future economic analysis of this type of contract and in stating that this would require the "collaboration with professionals and scholars in other disciplines" (p. 27).
Some problem areas that have been highlighted in studies are: agency costs, adverse selection, and moral hazard. Each of these aspects is briefly defined and explained below.
Expenditures for monitoring, perceived to be necessary, are critical costs in a principal/agency relationship. Since the principal is delegating authority and responsibility, prudent management...
To continue reading
Request your trial