agency theory

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The simplest agency model involves a single individual, called the agent, who acts on behalf of another, called the principal. Examples include an employee and employer; a board member and shareholders; or a contractor, lawyer, or broker and the client. The returns to the agent's actions accrue to the principal except for those personal costs that the agent directly bears. The challenge of agent-principal relationships is to motivate the agent to work as hard, cleverly, and effectively as the principal wants within the bounds of what the principal is willing to pay for the agent's activities on the principal's behave. )Roberts, 2004, pp 126-127)

The basic theory of agency assumes that enforceable contracts can be written on the observed performance measures, even though the actual desired behavior is not directly contractible. There are issues with contracts were performance cannot be clearly articulated, mutually understood, and have an unambiguous basis for evaluating performance. (Roberts, 2004, pp 159-160)

Two types of difficulties with subjective contracts -- with a firm's incentive to actually carry through on it promises to pay the appropriate rewards when they have been earned with subjective performance evaluations

  • once the job has been done, the principal may gain by reneging on the promise to pay rewards, claiming shortcomings in the performance
    • also, perceived arbitrariness and ambiguity in evaluations can undermine incentives
    • or, rewards may be paid that were not really earned
  • the subjective performance evaluation may be subject to influence by the agent, marshaling arguments and evidence of performance, even if that means doing the same to try to make others look bad.

Solution to subjectivity issues --
The solution to subjectivity issues in contracting agents lies in the principal's reputation to be trusted to not act opportunistically or be swayed by influence activities.