Explain the principles of agency theory, including the issues it addresses. What are some effective ways to deal with agency problems, as implied or stated by agency theory?

Question

What will be an ideal response?

Answer 1

Agency theory addresses situations where one individual or group (the principals) relies on another individual or group (the agents) to make decisions and take actions on their behalf. In many of these situations, there are opportunities for mutual gain, but there are also opportunities for the agents to act in their own best interests, to the detriment of the principals. Opportunities for exploitation exist because agents have more access to information about the situation and to other resources than do the principals. Therefore, the principals cannot fully monitor the actions of the agents and must trust the agents to some extent.?One way to manage agency problems is to align the two parties' goals, that is, to create opportunities for mutual gain and reduce opportunities for one-sided gain. For example, if corporate managers are compensated based on stock price, then they are more likely to work toward increasing stock returns, which would also benefit stockholders. If managers are compensated based on the size of the firm, then they will work toward increasing the size of the firm, which may not be beneficial for stockholders. Another tactic is to reduce information asymmetry to the extent possible by overseeing or monitoring the principals' actions closely. However, there will always be a need for the principal to trust the agent to some extent.