Agency Theory

When human interaction is viewed through the lens of the economist, it is presupposed that all individuals act in accordance with their self-interest. Moreover, individuals are assumed to be cognizant of the self-interest motivations of others and can form unbiased expectations about how these motivations will guide their behavior. Conflicts of interest naturally arise. These conflicts are apparent when two individuals form an agency relationship, i.e. one individual (principal) engages another individual (agent) to perform some service on his/her behalf. A fundamental feature of this contract is the delegation of some decision-making-authority to the agent. Agency theory is an economic framework employed to analyze these contracting relationships. Jensen and Meckling (1976) present the first unified treatment of agency theory.

Unless incentives are provided to do otherwise or unless they are constrained in some other manner, agents will take actions that are in their self-interest. These actions are not necessarily consistent with the principal's interests. Accordingly, a principal will expend resources in two ways to limit the agent's diverging behavior: (1) structure the contract so as to give the agent appropriate incentives to take actions that are consistent with the principal's interests and (2) monitor the agent's behavior over the contract's life. Conversely, agents may also find it optimal to expend resources to guarantee they will not take actions detrimental to the principal's interests (i.e. bonding costs). These expenditures by principal and/or agent may be pecuniary/non-pecuniary and are the costs of the agency relationship.