Principle Agency theory (PAT)

Agency theory is used to understand the relationships between agents and principals. The agent represents the principal in a particular business transaction and is expected to represent the best interests of the principal without regard for self-interest. The different interests of principals and agents may become a source of conflict, as some agents may not perfectly act in the principal’s best interests. The resulting miscommunication and disagreement may result in various problems within companies. Incompatible desires may drive a wedge between each stakeholder and cause inefficiencies and financial losses. This leads to the principal-agent problem.

The principal-agent problem occurs when the interests of a principal and agent are in conflict. Companies should seek to minimize these situations through solid corporate policy. These conflicts present normally ethical individuals with opportunities for moral hazard. Incentives may be used to redirect the behavior of the agent to realign these interests with the principal’s. Corporate governance can be used to change the rules under which the agent operates and restore the principal’s interests. The principal, by employing the agent to represent the principal’s interests, must overcome a lack of information about the agent’s performance of the task. Agents must have incentives encouraging them to act in unison with the principal’s interests. Agency theory may be used to design these incentives appropriately by considering what interests motivate the agent to act. Incentives encouraging the wrong behavior must be removed and rules discouraging moral hazard must be in place. Understanding the mechanisms that create problems helps businesses develop better corporate policy.

A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving problems that can exist in agency relationships; that is, between principals (such as shareholders) and agents of the principals (for example, company executives). The two problems that agency theory addresses are: 1.) the problems that arise when the desires or goals of the principal and agent are in conflict, and the principal is unable to verify (because it difficult and/or expensive to do so) what the agent is actually doing; and 2.) the problems that arise when the principal and agent have different attitudes towards risk. Because of different risk tolerances, the principal and agent may each be inclined to take different actions. An agency, in general terms, is the relationship between two parties, where one is a principal and the other is an agent who represents the principal in transactions with a third party. Agency relationships occur when the principals hire the agent to perform a service on the principals’ behalf. Principals commonly delegate decision-making authority to the agents. Agency problems can arise because of inefficiencies and incomplete information. In finance, two important agency relationships are those between stockholders and managers, and stockholders and creditors.

SCM and PAT

PAT is concerned with the governance and control mechanism structure of firms to mitigate the chances of opportunism, conflicting interests and information asymmetry between the Principle (delegating authority) and the Agent. Contracts are used as governance and control mechanisms whilst incentives are provided for meeting the minimum expected standards of the Principle.