Agency Theory

Agency Theory

Posted on by HKT

Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. Most commonly, that relationship is the one between shareholders, as principals, and company executives, as agents.

An agency, in broad terms, is any relationship between two parties in which one, the agent, represents the other, the principal, in day-to-day transactions. The principal or principals have hired the agent to perform a service on their behalf.

Principals delegate decision-making authority to agents. Because many decisions that affect the principal financially are made by the agent, differences of opinion, and even differences in priorities and interests, can arise. Agency theory assumes that the interests of a principal and an agent are not always in alignment. This is sometimes referred to as the principal-agent problem.

Financial planners and portfolio managers are agents on behalf of their principals and are given responsibility for the principals’ assets. A lessee may be in charge of protecting and safeguarding assets that do not belong to them. Even though the lessee is tasked with the job of taking care of the assets, the lessee has less interest in protecting the goods than the actual owners.

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Moral Hazard: The Multitask Incentive Problem

It is often the case that the agent does not exert a single-dimensional effort, par- ticularly when he is involved in many related activities associated with

Moral Hazard: More than Two Levels of Effort

1. A Discrete Model Let us extend the model of chapter 4 by allowing more than two levels of effort. Consider the more general case, with

Incentive and Participation Constraints with Moral Hazard

In chapter 4, we stressed the various conflicts that may appear in a moral hazard environment. The analysis of these conflicts, under both limited liability and

Nonverifiability in agency theory

When two parties engage in a relationship, it is often the case that they are uncer- tain about the value of some parameter that will affect

Moral Hazard: Redistribution and Moral Hazard

In chapter 3, we have already seen how the conflict between incentive compat­ibility and budget balance leads to the under-provision of output in an adverse selection

Moral Hazard: Nonseparability of the Utility Function

The separability in transfer and effort of the agent’s utility function simplifies the principal-agent theory with moral hazard by ensuring that the agent’s participation constraint is

Nonverifiability: Nash Implementation

In section 6.2, we have just seen how the principal and the agent can achieve ex post efficiency through an ex ante contract when they are

Nonverifiability: Incentive Compatible Contract

Instead of waiting for the realization of the state of nature, the principal can offer to the agent, at the ex ante stage (date t =

Nonverifiability: No Contract at Date 0 and Ex Post Bargaining

With the same model as in chapter 2, we now assume that the parameter θ is unknown at the contracting date (date t = 0) but

Nonverifiability in agency theory

When two parties engage in a relationship, it is often the case that they are uncer- tain about the value of some parameter that will affect

Moral Hazard: Redistribution and Moral Hazard

In chapter 3, we have already seen how the conflict between incentive compat­ibility and budget balance leads to the under-provision of output in an adverse selection

Moral Hazard: Nonseparability of the Utility Function

The separability in transfer and effort of the agent’s utility function simplifies the principal-agent theory with moral hazard by ensuring that the agent’s participation constraint is

Mixed Models: Moral Hazard Followed by Nonverifiability

The last stage of our travel in the world of mixed models brings us to the analysis of models with both moral hazard and nonverifiability. We

Mixed Models: Moral Hazard Followed by Adverse Selection

Sometimes an agent undertakes an initial nonverifiable investment or performs an effort before producing any output for the principal. For instance, the agent can choose a

Mixed Models: Adverse Selection Followed by Moral Hazard

In the standard moral hazard framework of chapter 4, it was first assumed that the agent had no private information of his own. In insurance markets,

Mixed Models of agency theory

The pure models of chapter 2 for adverse selection, chapter 4 for moral hazard and chapter 6 for nonverifiability were highly stylized contracting settings. Each of

Nonverifiability: Risk Aversion

The previous sections have discussed how various sorts of mechanisms may help to implement the first-best allocation rule when both the principal and the agent are

Nonverifiability: Subgame-Perfect Implementation

From proposition 6.4, a necessary condition for unique Nash implementation is that an allocation rule a(·) be monotonic. Any allocation rule that fails to be monotonic

Agency theory: Limits to Enforcement

In this volume, we have assumed that the judicial system is perfect and benevo- lent, and consequently can enforce any contract without cost. Implicit behind this

Agency theory: Informed Principal

In the basic framework of chapter 2, we have assumed that the uninformed party has all the bargaining power and makes a contractual offer to the

Dynamics under Full Commitment – Constraints on Transfers: The Role of Implicit Incentives

In section 4.7, we reported the Fama (1980) argument according to which the labor market acts as an incentive instrument and provides managers with incentives to

Dynamics under Full Commitment: Repeated Moral Hazard

Let us now move to repeated moral hazard relationship. The main goal of this section is to show how the past history of performances may help

Dynamics under Full Commitment: Repeated Adverse Selection

Consider the twice repetition of the model in chapter 2, where we can make various assumptions on the information structure and, in particular, on how it

Dynamics under Full Commitment in Agency Theory

Contracts are often repeated over time. Examples of such long-term relationships abound and span all areas of contract theory. Let us describe a few. The insurance

KEY TAKEAWAYS

  • Agency theory attempts to explain and resolve disputes over priorities between principals and their agents.
  • Principals rely on agents to execute certain transactions, particularly financial, resulting in a difference in agreement on priorities and methods.
  • The difference in priorities and interests between agents and principals is known as the principal-agent problem.
  • Resolving the differences in expectations is called “reducing agency loss.”
  • Performance-based compensation is one way that is used to achieve a balance between principal and agent.
  • Common principal-agent relationships included in agency theory include shareholders and management, financial planners and their clients, and lessees and lessors.