Understanding Agency Theory: Definition And Features

Organisations often consider the professionals within the organisation as part of different groups. One way some organisations consider their professionals is to separate them into groups called agents and principals. Understanding why organisations do this can help you consider the relationship between these two groups and how it affects the organisation's success. In this article, we discuss why understanding agency theory is important, including its components, look at how to resolve disputes and list ways to reduce agency loss within an organisation.

Understanding Agency Theory

Understanding agency theory is all about knowing what it is and how it works. An agency is a professional relationship between two parties. The first party are agents, and the second party are principals. In this relationship, the agents represent the principals in the daily interactions of the agency. These interactions can include transactions, sales, marketing and lead generation. In this relationship, the principals hire agents to perform specific duties for the agency. For example, a principal, such as a chief operations officer, may hire a writer to create content for the organisation.

To create an effective agency, the principals in the relationship delegate some of their decision-making power to agents. This means that the agent or agents make many of the decisions that affect the finances of the organisation and the principal. Another part of this relationship is that the resources and assets an event uses belong to a principal or principal. For example, a financial planner may use their clients' resources to perform their duties. This can create differences in opinion between principals and agents, especially when the principal experiences financial losses.

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Principals Vs. Agents

Agency theory assumes that the interests of principals and agents do not always align. This conflict is the principal-agent problem. In this challenge, the goals and expectations of principals and agents are different. For example, a principal within an organisation may decide to increase the short-term financial gains of the organisation, while an agent may use resources to create a basis for long-term financial gains for the organisation.

The roles of principals and agents can differ from organisation to organisation, so the specific disputes they experience can vary. For example, a financial planner may want to increase long-term stability as the agent in the relationship, while a sales professional may want to increase their sales to earn a commission and increase their short-term earnings, even as an agent in their professional relationship. Similarly, a company owner may recognise the need for their organisation to have low-risk markets for stability, while another wants to increase the short-term financial gains of their organisation even though it is riskier.

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Disputes In Agency Theory

Below are descriptions of the two areas of dispute that occur in agency theory:

Differences in goals

One type of dispute between agents and principals that occurs in agency theory is a difference in goals. In this, the outcomes for long-term and short-term goals for each party are different. For example, the agent of an organisation wanting more stability in their role and the roles of other agents may decide to create systems within the organisation to support their roles. The principal of the same organisation may not have the same goal. For example, the principal may want to continue spending on marketing and sales professionals without the stability so they can create more organisational profits.

While the two parties may have differences in goals, they can communicate their goals to create alignment between both positions. Both parties can also choose to complete one goal for one group and another for the other group.

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Differences in risk aversion

Another dispute that can occur is a difference in risk aversion between the principal and the agent in the relationship. This area of dispute is very common in financial investing because the correct amount of risk from a financial planner's point of view and an investment holder's point of view can be very different. For example, a financial planner may recommend a high-risk investment because the rest of the client's portfolio is very stable and risk-averse. The client may not want that investment because of its risk, even though it may earn them more money from the portfolio.

Both parties can communicate to minimise the occurrence of this type of dispute, just as they can when they have different goals. They can also plan for balancing risky and risk-free assets and decisions within the relationship.

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What Is Agency Loss And How Can You Reduce It?

Agency loss is how much a principal considers being lost because an agent acted in a way contrary to how the principal does. This is an important component of agency theory because it describes the relationship between the principal and their agents in terms of what the principal expects and how the agents behave. Below are tips you can use to reduce agency loss in an organisation:

Increase communication

A major way to decrease agency loss is to increase the amount of communication between principals and agents. Taking this step can help both parties understand the goals and outcomes the other expects and wants. There are many ways to communicate. A principal can create a feedback system so they can provide feedback to their agents and agents can provide feedback to the principal. You can also use an email or newsletter system that explains the goals of the organisation for the period it is in. Direct communication between the principal and agents can help everyone understand the organisation's goals.

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Offer incentives

One way principals can create more alignment with their goals is to offer incentives to their agents. This is especially effective in business settings, where the performance of agents directly affects the finances of the business. Incentives can include cash bonuses, extra time off, promotions and recognition with the organisation. Incentives for meeting the principal's goals can increase alignment because more agents want to meet that incentive goal. For example, offering a pay bonus to the sales professional with the most sales conversions can help the organisation grow its leads and profits in the short term.

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Connect principal salaries to agent returns

Another way to reduce agency loss is to connect the salaries or payment of the principals to how the agents they manage or lead perform. This creates more accountability between the principal and the agents, which helps them align their goals more effectively. For example, connecting the money a company owner makes to the success of professionals within the organisation encourages the company owner to communicate with the professionals so that they can meet goals set by the owner. This also ensures the principal does not feel as though the agents are wasting resources or limiting profits.

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Connect principal salaries to long-term goals

Another way to affect the salary of a professional such as a business owner is to connect their earnings to the achievement of long-term goals. Typically, a business owner leans towards making decisions that affect the short-term profits of an organisation, which can create disputes between them and the professional agents within their organisation. Connecting their salary to their long-term goals encourages them to consider whether their short-term decisions can affect long-term goals negatively. This also encourages them to make better decisions for everyone within the organisation, which decreases the number of disputes between them and the organisation's agents.

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Consider long-term and short-term goals

A major part of running an organisation or having a relationship between agents and principals is the decision-making process. In this process, both parties consider the long-term and short-term goals of the organisation or relationship. Doing this can help both parties understand how the decisions can affect the organisation. In a business setting, agents often consider the long-term longevity of the organisation, while principals consider short-term benefits. Considering both can help agents and principals make better decisions for the organisation because they predict the effects of their decisions, which can have a major impact on the organisation's performance.