What is the Agency Problem?
An agency relation is created when any person or a group of persons, referred to as agents, are appointed to act on behalf of any other person/organisation, referred to as the principal. An agency problem arises when he uses his authority for his own benefit instead of the principal’s benefit.
Thus, in simple words, an agency problem arises when there is any disagreement or conflict of interest amongst agent and principal.
Example of Agency Problem
One can encounter various scenarios where they can see agency problems. For example, any time when the agents fail to do their duty or take any decision in their own interest instead of their duty is an agency problem.
A simple example can be of a bank. When we deposit money in our bank account, the bank pays us interest on that. Now, if the bank management denies paying their interest, it is nothing but an agency problem. Because in such a scenario, customers may well keep the money with themselves, which eventually will impact the bank’s business.
Another example can be of the management or directors of a company. Again, if they don’t work efficiently, work in a manner that the decisions are taken in their own interest, it is an agency problem.
Types of Agency Problem
In an organisation, there can be various agency problems amongst different groups such as:
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1. Management vs Owners
An organization appoints outside professionals who manage and run the company. However, if the management takes decisions that are not in favour of the business, then there can be conflicts between them and owners, which is nothing but known as an agency problem.
2. Customer vs Owners
Yes. They can be conflict amongst customers and owners as well. For example, say the company decides to increase the price of the product; in such a case, the customer may not buy the product and may shift towards other competitors’ products.
3. Senior vs Junior
In any organisation, there are various people employed who look after the overall management of the company. Usually, people at a higher managerial level take decisions or draft the steps to be taken and followed by all. There is a high possibility that people at lower or base levels may have a conflict here.
4. Employees vs Owners
Employees may want a better raise or incentive, and in case the company decides to not adhere to the same, there may be a conflict between employees and owners or management.
5. Creditors vs Owners
Here, the problem can arise when the owners may take certain decisions that entail a high risk to earn higher rewards. In order to fetch big or risky projects, the owners will have to fetch more loans. And say in a turnaround event of them incurring losses in the project or the project failing to achieve the desired profitability, the creditors will lose money, and thus in such a situation, conflicts may arise between creditors and owners.
Reasons Behind Agency Problem
An agency problem occurs when there is a conflict or a disagreement between agent and principal. An agent is supposed to act in the best interest of its principal and on maximizing his benefit. A conflict mostly arises when the agent puts his personal interest ahead of his professional one.
In other words, when an agent makes a commercial decision which is for his individual benefit and not for the organization/ principal, the agency problem comes into the picture.
Solutions for Agency Problem
In order to avoid agency problems, one must ensure appropriate incentives to the agent / authorized representatives so that they are compensated for their efforts.
Following are few ways in which we can solve it:
- Hiring ethical managers
- Getting a financial audit done
- Performance-based incentives
- Stock options – having ownership in organisation will make them take righteous decisions.
- Recognition/awards for highlighting their achievements
- Incentives based on results rather than time spent
Impacts of Agency Problem
The presence of agency problems may affect organisations interests as the same might be overlooked, thus impacting the business being carried on. In addition, any decision taken by management which is not in the larger interest of the organisations will ultimately have a bearing on stockholders’ wealth. Thus, steps must be taken to ensure that agency problems are reduced as much as possible such that management is motivated to put the interest of the organisation and stockholders ahead of its own.
Why is the Agency Problem Important?
The agency problem is important as it is used to measure the relationship amongst the people who are involved in running the organisation or who have important roles in the organisation.
It would not be wrong to say that management is considered unethical to exploit the owners/stockholders’ interest to feed their own benefits.
Management generally comprises professionals who are hired to look after the business and take decisions for the same. It is always good to keep management and ownership different. However, it comes with its own set of concerns.
Key Takeaways
It is nothing but incompatibility between any two parties, wherein one party is bound to act in the best interest of the other. It can arise when the incentives received by the agent are not compensatory enough for them to stay motivated to continue acting in the best interest of principal.
It can be avoided by taking measures to compensate each group in such a way that the incentive or compensation keeps them motivated to work in larger interest. You may note that agency problem is something which cannot be avoided totally, but then it can definitely be reduced.
Conclusion
To summarize the whole discussion, agency problem is simply a difference of opinion between the people who help operate and manage the organisation and its owners. People who manage the organisation, such as management, employees, and lenders, act in the organization’s best interest, ultimately help achieve maximum benefits to its owners and simultaneously be compensated for it. The concern or problem arises when these people, instead of maximizing owners’ wealth, they focus on their own interest. Therefore, although we cannot get rid of agency problem, as an stockholders’ do need professional people to manage the organisation, it is in the best of both parties to work on this problem and minimize it to the extent possible.
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This is a guide to Agency Problem. Here we also discuss the introduction and types of agency problem along with example. You may also have a look at the following articles to learn more –
