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What Is Agency Theory?

Agency Theory involves the relationship between a person delegating work and another person that performs the work.
Research indicates that two parties will have more closely aligned goals when their contract is outcome-based.
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  • Originally Written By: Renee O'Farrell
  • Revised By: C. Mitchell
  • Edited By: J.T. Gale
  • Last Modified Date: 28 July 2014
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Agency theory is an economic concept that explains why behavior or decisions vary between members of a group. It can apply to almost any particular “set” of people who spend some or all of their time in similar situations, from school classes and local communities to industry groups and religious sects. Most of the time it is discussed in terms of business, though, and it emerged as a principle of corporate economics. The theory describes the relationship between one party, called the principal, who delegates work to another, called the agent. It explains their differences in behavior or decisions by noting that the two parties often have different goals and, independent of their respective goals, may have different attitudes toward risk. Analysts often rely on this theory in order to make predictions about how teams will function and the degree of success certain people-led ventures are likely to obtain.

Basic Premise

The theory essentially sets out how different parties involved in the same situation with the same goal will often have different motivations, and it goes on to look at how these different motivations can sometimes lead to widely varying results. It states that there will always be partial goal conflict among parties, and argues that efficiency is inseparable from effectiveness. In addition, it posits that information will always be somewhat asymmetric between principal and agent.

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Analysts use agency theory to make predictions about how interactions will happen in many different fields, though it’s often the most common in accounting, economics, and the financial sector. Marketing specialists use it too, as do political pundits and sociologists. It isn’t usually a way to determine anything definitively, but having an educated guess about how people will act under certain circumstances and with certain motivations can help shape predictions about future performance and, by extension, industry success or failure.

Where the Concept Came From

The concept originated from the work of Adolf Augustus Berle and Gardiner Coit Means, two American economists who began discussing corporate governance in terms of an “agent” and a “principal” as early as 1932. Berle and Means explored the concepts of agency and their applications toward the development of large corporations and they saw how the interests of the directors and managers of a given firm differed from those of the owner. They used the concepts of agency and principal to explain the origins of those conflicts.

Two more American economists, Michael Jensen and William Meckling, further refined shaped the work of Berle and Means in the context of risk-sharing research, and most scholars credit these two with the actual coining of the formalized “agency theory.” Jensen and Meckling formed a school of thought arguing that corporations are structured to minimize the costs of getting agents to follow the direction and interests of the principals.

Research Findings

Research applying the theory to practical situations has had several findings over the years. Most notably, an agent is more likely to adopt the goals of the principal, and therefore behave in the interest of the principal, when the contract is outcome-based. Also, when the agent is aware of a mechanism in place that allows the principal to verify the behavior of the agent, he is often more likely to comply with stated or set goals.

Furthermore, outcome uncertainty has generally been shown to have a positive relationship to behavior-based contracts, while there is usually a negative relationship to outcome-based contracts. Goal conflict similarly has a negative relationship to behavior-based contracts but a positive relationship when they’re outcome-based. Outcome measurability in all of these cases is usually negatively related to behavior-based contracts, while there is usually a positive relationship with respect to outcome-based contracts.

Common Criticism

Opponents to agency theory often criticize it for being too general, and many also claim that it is “pseudo-scientific” which, in the context of personal interactions, isn’t usually a good thing. The theory is open to some interpretation, and some critics say that it is by its nature subjective, and its validity not testable. Hypotheses usually need to be tested in order to be proved.

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Discuss this Article

anon276732
Post 5

Is agency theory really applicable in the case of donors and organizations they fund?

ShadowGenius
Post 4

@FitzMaurice

I find it quite disturbing to work with people who seem to have a "problem with authority." I am usually the perceived authority, and can see people talking about me behind my back and only paying lip service. The jealousy and difficulty in taking orders can make work a hard place to be.

FitzMaurice
Post 3

Understanding the power-play and work ethics involved in organizational theory is an important aspect of creating an effective business. If you go into a work situation without a solid grasp of workplace psychology, you may be in for a bumpy road. Not only will customer relations be difficult, but maintaining a solid set of ideals for your business will be impossible if you fail to understand and get along with those who work for you.

GigaGold
Post 2

@Tufenkian925

I agree that there is relative randomness, but should this discourage people from making theories about sociology and human psychology? I think the science will look different than more "rigid" sciences and will probably be much more general, but it will nevertheless still be quite helpful for companies to understand and create new theories.

Tufenkian925
Post 1

I think that people who criticize this theory as being "pseudo-scientific" need to realize that you can't really put human thinking into a scientific box. We are very poor at understanding ourselves, and are so intricate in terms of societal function and personalities, that the best operations theory is one of relative randomness. Black swan theory seems to most accurately describe how people relate to one another. There is always an aspect of free-radical involvement which makes a rigid scientific understanding of how people relate to be impossible.

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