Agency Problem

Reviewed by Vineeth | Updated on Sep 28, 2020

Introduction

The agency problem is a scenario of a conflict of interest which is inherent in all relations wherein one party is anticipated to operate in the best interests of another party. In the field of corporate finance, the agency problem generally points the conflict of interest among the company’s stakeholders and the management of the company.

The mangers, who act as the shareholders’ agents, are tasked with the responsibility of making decisions that are going to maximise the wealth of the shareholders despite them acting in their best interest in order to enhance their own fortune.

Breaking Down Agency Problem

The agency problem is present with a relation between an agent and principal. In this scenario, the agent is going to perform a job as a representative of the principal. Agents are generally kept occupied by principals on the back of several levels of skills, job levels, and access to certain confidential information.

For instance, an electrician is going to be hired by a principal. Here the agent is the electrician. The best interest of the electrician is to pluck as much money as possible by performing his duties. Nevertheless, all the actions that the agent is going to perform benefits to the principal.

Drawbacks

The agency problem occurs because of the issues with the incentives and the task to be completed in the discretion. At times the agents can be prompted to function in a way that is unfavourable to the principal. This happens specifically if the agents are given with the incentives to act as such.

For instance, drawing from the example mentioned earlier, the electrician may go onto talk about a service which is absolutely not necessary. He might be tempted to do this as there is an incentive, causing the agency problem to string up.

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