Principal agent theory - Essay Example

The relationship that takes place between particular agents along with a particular principal is recognized as agency. Under the principal agent theory, the principals liability does not ends when authority is transferred to the agent and the principal continues to be liable to the third party for any shortcoming from the end of the agent. The agent principal theory is applied in various contexts such as employment and real estate. In case of employment a principal agent relationship arises when a owner of c particular company hires a manager to work or operate on his behalf while dealing with third parties.

In this case the principal is the owner of the company and the agent is the manager. Similarly, subordinates become agents and managers become agents when subordinates work on the behalf of the managers. In both cases the principal is held reliable for any wrong doings conducted by the agent. Issues in Principal Agent Theory Owners of a company are regarded as principals when they enter into a contract with the agents as agents accept that they will manage the principal’s business. . An issue between the agent and the principal does not take place until there is a coexistence of the benefits for both the principal and the agent.

A principal might end up experience cost of agency when the self interest of both the individuals deviates. This is because if the agents have the opportunity they will try to ensure that their own utility is maximized as they end up giving more importance to their self interest over the interest of the principal (Steiner, 2002, p.17). There is ample amount of probability that both the agents and the principals do not share mutual opportunities of benefits. The theory of agency even states that a principal cannot be sure whether agent will give importance to his own utility over the utility of the principal thus the principle tries to minimize losses that are projected towards his own utility.

They do so by keeping strict control over the agent and monitoring the behavior of the agent. The issue that is caused due to the self serving behavior of the agent is even recognized as hidden action (Stolle, 2008, p.63). An issue of hidden action arises as the agent may be involved in committing an act that cannot be observed by the principal or the principal does not have the information to identify what the agent is involved into. For example: In the case of real estate, an individual may hire a real estate agent to look for a home with certain characteristics and of certain price.

The principal doers not know where to look for a home that is compatible with his requirements and is even not aware of the price of such a house. The agent’s task is to locate such a house and quote the correct price of the house to the principal. Since the agent has the motivation of maximizing his/her utility he may