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Agency Theory

Balachandran, M.E., & Smith, M.O. (2000). “E-Commerce: accurate to describe it as a modeling approach within
The new frontier in marketing.” Business Education Forum, which there are some common structure and assumptions
54(4), 37-39.
with wide variations” (p. 27). Yet, in 2002 Eric Brousseau
Jones, J. P. (2004). Fables, fantasies, and facts about advertising. hinted at the incompleteness of the theory in considering
Thousand Oaks, CA: Sage Publications.
the future economic analysis of this type of contract and
Lane, W.R., King, K.W., & Russell, J.T. (2005). Kleppner’s in stating that this would require the “collaboration with
advertising procedure (16th ed.). Upper Saddle River, NJ:
Pearson/Prentice-Hall. professionals and scholars in other disciplines” (p. 27).
Museum of Broadcast Communications (2005). Retrieved from
http://museum.tv. SOME PROBLEMS IDENTIFIED
Stafford, M. R., & Faber, R. J. (2005). Advertising, promotion, Some problem areas that have been highlighted in studies
and new media. London: M. E. Sharpe. are: agency costs, adverse selection, and moral hazard.
Wells, W., Burnett, J., & Moriarty, S. (2000). Advertising: prin- Each of these aspects is briefly defined and explained
ciples & practice. Upper Saddle River, NJ: Prentice-Hall.
below.
Williams, T. (2004). “Evolve or die: The changing model of the
advertising agency.” Retrieved from http://
www.marketingprofs.com. Agency Costs. Expenditures for monitoring, perceived to
be necessary, are critical costs in a principal/agency rela-
tionship. Since the principal is delegating authority and
John A. Swope responsibility, prudent management undertakes some
Scott Williams type of monitoring to have assurance that decisions are
optimal from the point of view of the principal. Reports,
observational visits, and supervision are common types of
monitoring, none of which is cost-free.
AGENCY THEORY
Agency theory pertains to the relationship between two Adverse Selection. The incompleteness of information
parties; the first is the principal (or principals) and the sec- that is generally available to the principal and to the agent
ond, the agent (or agents), who are engaged as employees is the core concept of adverse selection. Agents present
or independent contractors. Considered a subunit of the their credentials in résumés; they discuss their qualifica-
theory of contracts, agency theory deals with the determi- tions in interviews. Based on such information, the prin-
nation of the general structure of such contractual rela- cipals conclude whether such agents are qualified or not
tionships and factors that influence behavior of the parties
for positions to be filled. In some instances, such résumés
involved.
are later found to contain inaccurate information, or rep-
While the principal/agent relationship was recog- resentations made in interviews are later recognized as not
nized in the writing of early economists, including Adam the same as what is learned about actual performance.
Smith, the identification of this special aspect of contracts
Principals, too, may misrepresent information or pro-
dates to the 1970s. A significant paper published in 1976
vide incomplete information. Principals in interviewing
by Michael Jensen and William Meckling identified ele-
prospective accountants, for example, may state that high
ments from the theory of agency in their consideration of ethical standards are to be maintained in processing and
the theory of the firm. They commented:
reporting financial information to shareholders. Agents
The firm is a “black box” operated so as to meet accept such representations as in line with their beliefs.
the relevant marginal conditions with respect to After accepting positions as accounting managers, though,
inputs and outputs, thereby maximizing prof- agents are informed that the company figures must reflect
its.… Except for a few recent and tentative steps, a specified level of profit for the end of the fiscal year,
however, we have no theory which explains how regardless of what the actual accounting records reflect.
the conflicting objectives of the individual partic- The words of the principal during the initial interview are
ipants are brought into equilibrium so as to yield not supported by the demand to manipulate the figures.
this results.
The theory has continued to evolve since the Jensen- Moral Hazard. The possibility that agents will not choose
Meckling paper was written. In noting the basic analyses to optimize the wishes of principals is the essence of this
still to be undertaken, J. Gregory Dees stated in 1992, problem. For example, a company executive hires a man-
“principal-agent analysis is a diverse and rapidly develop- ager for a manufacturing plant for which standards of out-
ing field.… While commonly referred to as ‘agency the- put have been established. The manager agrees to a fixed
ory,’ … I … believe the label is misleading. It is more income with no bonus. The manager soon learns that the

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 23