Theories Of Principal-Agent Relationship

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Principal-Agent relationships occur in many forms in business. Understanding these relationships is crucial for investors in order to make better investment decisions.
• Theory of Principal-Agent Relationships
As discussed in another article, the modern corporation can be conceptualized in a variety of ways. The set-of-contracts view illustrates that relationships between and among multiple stakeholders is complicated and provides many opportunities for one party to gain at the expense of another party. The Theory of Principal-Agent Relationships recognizes that there can be friction between relationships when one person acts for someone else.
• Principal-Agency Relationships Defined
Agency Theory refers to analyses associate with the Principal-Agent
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These benefits, however, are available because the corporate structure separates ownership from control. Stockholders, the owners of a corporation, do not directly control the interests of a firm. They hire managers to act on their behalf, the classic principal-agent relationship.
However, the relationship is actually a bit more complicated. The owners do not hire the employees of a company themselves. They actually hire top managers, human resources department, and others to hire people to act on behalf of the owners. This complexity can be illustrated further with the set-of-contracts theory of corporate structures. This theory states that organizational relationships are complex with many potentially conflicting legal and moral obligations to stakeholders. The ability to ensure that principal-relationships positively impact each stakeholder rests on the individual relationships that make up the entire system of agency created by the complexity of corporate
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In corporations, the set-of-contracts view of the firm illustrates the complexity of multiple agency relationships across many stakeholders. When an investor values a firm, the evaluation always takes into account the risk associated with the separation of ownership and control.
• Key terms
Principal-Agent Relationship: The arrangement that exists when one person or entity acts on behalf of another. For example, shareholders of a company elect management to act on their behalf, and investors choose fund managers to manage their assets. This arrangement works well when the agent is an expert at making the necessary decisions, but doesn't work well when the interests of the principal and agent differ substantially. In general, a contract is used to specify the terms of a principal-agent relationship.
Stakeholder: A person, group or organization that has interest or concern in an organization. Stakeholders can affect or be affected by the organization's actions, objectives and policies. Some examples of key stakeholders are creditors, directors, employees, government (and its agencies), owners (shareholders), suppliers, unions, and the community from which the business draws its

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