AGENCY THEORY
The principal agent problem is a core part of agency theory, which views the firm as a nexus of legal contracts. in this perspective, corporations are viewed merely as a set of legal contracts between different parties. Conflicts that may arise are to be addressed in the legal realm. Agency theory finds its everyday application in employment contracts, for example.
Besides dealing with the relationship between shareholders and managers. principal agent problems also cascade down the organizational hierarchy (shown in Exhibit 12.3). Senior executives. such as the CEO, face agency problems when they delegate authority of strategic business units to general managers. Employees who perform the actual operational labor are agents who work on behalf of the managers. Such front line employees often enjoy an informational advantage over management. They may tell their supervisor that it took longer to complete a project or serve a customer than it actually did, for example. Some employees may be tempted to use such informational advantage for their own self interest (e.g., spending time on Facebook during work hours, watching YouTube videos, or using the company's computer and Internet connection for personal business).
The managerial implication of agency theory relates to the management functions of organization and control: The firm needs to design work tasks, incentives, and employment contracts and other control mechanisms in ways that minimize opportunism by agents. Such governance mechanisms are used to align incentives between principals and agents. These mechanisms need to be designed in such a fashion as to overcome two specific agency problems: adverse selection and moral hazard.