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Agency Theory

Agency theory is a concept in economics and management that examines the relationship between two parties: a principal and an agent. The principal is the owner or manager of an organization, while the agent is the person who is hired to carry out specific tasks on behalf of the principal. The theory explores the incentives, conflicts, and strategies that arise when the principal delegates authority to the agent.

In an ideal situation, the principal and the agent should work together towards a common goal. However, in reality, the interests of the principal and the agent may not always align. This is because the principal may not have complete information about the agent’s actions, and the agent may not always act in the principal’s best interests.

To address this problem, agency theory suggests that the principal should provide incentives to the agent that align with the principal’s goals. These incentives may include bonuses, performance-based pay, and other rewards that encourage the agent to work towards the principal’s goals. Additionally, the principal may also monitor the agent’s actions and provide feedback to ensure that the agent is acting in the principal’s best interests.

However, providing incentives and monitoring the agent can be costly for the principal. The cost of monitoring and providing incentives can be seen as agency costs, which are the costs associated with managing the relationship between the principal and the agent. These costs can be minimized by designing contracts that align the interests of the principal and the agent.

One of the most important applications of agency theory is in corporate governance. In this context, agency theory is used to analyze the relationship between shareholders, who are the principals, and managers, who are the agents. The theory helps to explain why managers may act in their own self-interest rather than in the interests of the shareholders.

To address this problem, corporate governance mechanisms, such as board oversight, executive compensation, and shareholder activism, are put in place to align the interests of managers with those of shareholders.

In conclusion, agency theory is a useful concept in economics and management that helps to explain the relationship between a principal and an agent. The theory suggests that principals should provide incentives that align with their goals and monitor the actions of their agents. The application of agency theory is particularly important in corporate governance, where it is used to align the interests of shareholders with those of managers. By understanding the principles of agency theory, organizations can design effective contracts and governance structures that promote cooperation and alignment between principals and agents.


Joseph Muongi

Financial.co.ke was founded by Mr. Joseph Muongi Kamau. He holds a Master of Science in Finance, Bachelors of Science in Actuarial Science and a Certificate of proficiencty in insurance. He's also the lead financial consultant.