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Agency Theory (Corporate Governance)

💼 Business By CampusDown Wiki Editorial Team Last updated
Quick answer: agency theory explains the problem that arises when shareholders (principals) entrust a company to managers (agents) who may pursue their own interests rather than the shareholders', and the mechanisms that reduce the resulting costs. It is the basic framework of corporate governance debates.
Contents
  1. 1. Background: separation of ownership and control
  2. 2. Jensen and Meckling's agency costs
  3. 3. Information asymmetry and moral hazard
  4. 4. Governance mechanisms
  5. 5. Limits
  6. 6. References

Background: separation of ownership and control

Berle and Means (1932) observed that as the shares of large US corporations became dispersed among many shareholders, real control passed to managers. Once owners and managers are different people, there is no guarantee that managers will faithfully pursue shareholders' interests.

Jensen and Meckling's agency costs

Jensen and Meckling (1976) defined an agency relationship as a contract under which one person (the principal) delegates decision-making authority to another (the agent), and argued that if both parties maximize their own utility, the agent will not always act in the principal's best interest. They divided the resulting costs into three kinds.

  • Monitoring costs: what the principal spends to monitor and control the agent's behaviour.
  • Bonding costs: costs the agent bears to guarantee that it will not harm the principal.
  • Residual loss: the gap that remains, despite monitoring and bonding, between the agent's decisions and those that would be best for the principal.

Information asymmetry and moral hazard

Eisenhardt (1989) summarized the core problem of agency theory as principals and agents having different goals while the principal cannot fully observe the agent's behaviour. Typical cases are moral hazard, caused by hidden action after the contract, and adverse selection, caused by hidden information before it. Whether to monitor behaviour or to tie rewards to outcomes therefore becomes the central question of contract design.

Governance mechanisms

Fama (1980) and Fama and Jensen (1983) saw the board of directors as monitoring managers by separating the implementation of decisions from their control. Other mechanisms discussed as reducing agency problems include performance-based pay such as stock options, a market for corporate control in which hostile takeovers are possible, debt that reduces free cash through interest obligations, and external audit and audit committees.

Limits

Agency theory is criticized for viewing managers only as self-interested. Stewardship theory instead sees managers as stewards committed to the organization, and others point out that in firms with concentrated ownership a different conflict, between controlling and minority shareholders, matters more.

See also: Merger and Acquisition Motives (Synergy Hypothesis), Corporate Social Responsibility (CSR), Earnings Management and the Big Bath

References

  1. Berle, A. A., & Means, G. C. (1932). The Modern Corporation and Private Property. Macmillan.
  2. Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360.
  3. Fama, E. F. (1980). Agency problems and the theory of the firm. Journal of Political Economy, 88(2), 288-307.
  4. Fama, E. F., & Jensen, M. C. (1983). Separation of ownership and control. Journal of Law and Economics, 26(2), 301-325.
  5. Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of Management Review, 14(1), 57-74.

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There are no materials dedicated to this theory yet, but you can search related reports in the CampusDown library (Korean).

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This article was last updated on October 15, 2026. It is based on widely recognized original works and textbooks; when citing it in a paper, please check the original sources listed in the references.