Agency Theory

Agency Theory

Principal hires an agent to represent its interests Homeowner (principal) hires broker (agent) to sell house car owner (principal) hires mechanic (agent) to repair car Stock holders (principal) hires managers (agent) to run the company

Agency Problem

Conflict of interest between principal and agent Real Estate brokers may not have an incentive to search for the highest selling price Mechanics may not have the goal of keeping repair costs low managers may not care abt maximizing shareholder wealth These problems occur because of asymmetric information and monitoring costs

Information

Brokers have a better understanding of the demand for houses but may wish to sell the house rather than wait for a better offer to come by. They do get a percentage of the sale price, but most of the gain goes to the home owner. Mechanics have greater info. abt  workings of car and possible repair options. They may have an incentive to perform more elaborate repair job when a less costly alternative is sufficient

Information and Incentive

Managers may not have incentive to work to increase shareholder wealth. Its costly to monitor managers.

Solution to agency problem

For brokers and mechanics, use online rating sites. For managers, use stock options Require managers to purchase shares of company (using their own money). Possibility of a corporate takeover can also provide incentive to maximize shareholder wealth.