Agency Theory
Agency theory is an area of economics and finance that examines the relationships between principals, such as shareholders or investors, and their agents, such as managers or corporate executives. Agency theory investigates how these two groups interact when making decisions for a company in order to maximize profits and minimize risk. The main focus of agency theory is to assess the incentives available to each party involved in order to ensure that they both have the same goals – maximizing returns for all parties with minimal risk.
The concept of agency theory was first proposed by Michael Jensen and William Meckling in 1976. It explains why firms exist and why different stakeholders may have different objectives if left unchecked. By understanding how incentives affect behavior, it allows companies to better align interests while creating viable strategies that benefit everyone involved.
One example of an incentive used in agency theory is compensation based on performance relative to a benchmark like the market index or peer group average return; this encourages managers to act in ways that increase shareholder value rather than simply provide short-term gains at any cost (e.g., cutting corners on safety). Additionally, directors can be incentivized through stock options which encourage them to make decisions with long-term success over short-term gains since their reward depends upon sustained performance improvements over time rather than a one-time cash payment for good results today regardless of future consequences tomorrow.
In conclusion, agency theory provides insight into how stakeholder interests can be aligned so as not only optimize financial returns but also reduce moral hazard risks associated with decision making within organizations – ultimately leading towards greater efficiency overall throughout the entire organization’s life cycle from start up through retirement/liquidation stages
