Agent theory is a fundamental framework in economics and organizational studies. It examines the relationship between a principal, who delegates authority, and an agent, who acts on the principal's behalf. This theory addresses the conflicts that arise when the principal and agent have different goals and when information asymmetry exists between them.
The core problem in agent theory arises from two key factors. First, the principal and agent often have different objectives. For example, a company owner wants to maximize profits, while the manager might prefer to minimize effort or maximize personal benefits. Second, information asymmetry exists where the agent typically has more information about their actions and the situation than the principal does.
Agency theory identifies two main types of problems. Moral hazard occurs when the agent changes their behavior after the contract is signed, such as an employee working less hard once they have job security. Adverse selection happens when the agent has hidden information before the contract is made, like a job candidate concealing their lack of relevant skills during the hiring process.
To address agency problems, principals can implement several solutions. Performance-based incentives like bonuses and stock options align the agent's financial interests with the principal's goals. Monitoring through audits and regular reports helps reduce information asymmetry. Well-designed contracts with clear terms and penalties can prevent opportunistic behavior. Reputation mechanisms encourage long-term thinking, as agents want to maintain their professional standing.
Agent theory has broad applications across many fields. In corporate governance, it explains the relationship between shareholders and management. In financial markets, it helps understand conflicts between investors and fund managers. The insurance industry uses it to address moral hazard in policy design. Employment contracts are structured to minimize agency costs. Political science applies it to voter-politician relationships, and healthcare systems use it to align doctor and patient interests with institutional goals.