The theory of the contractual relationship between a principal and an agent. Agent theory analyses the issues that arise when a principal delegates a task to an agent but there is asymmetric information and an incomplete contract. The basis of the analysis is that the principal and the agent have different objectives. For example, the owner of a firm (the principal) may wish to maximize profit but the manager of the firm (the agent) aims to maximize a utility function that is increasing in income but decreasing in effort. The first-best contract would make the reward a function of effort and be designed to induce the efficient effort level in every circumstance. The agency problem arises when there is an asymmetry of information such that the principal cannot observe the effort level of the manager and hence cannot condition the contract upon it. Instead, the contract has to be conditioned upon an observable and verifiable quantity such as the level of profit. This prevents the contract from ensuring that the efficient level of effort is always supplied. The design of the contract has to take into account incentive effects and the allocation of risk between the principal and the agent. It is often assumed that the principal is risk-neutral and the agent risk-averse, in which case, putting incentive effects to one side, all of the variability in pay-off should fall on the principal. Such a contract does not provide any incentive for the agent, so leading to the balance of risk sharing and incentives. The need to provide an incentive to the agent makes the expected profit of the principal lower than that with the first-best contract that could be used with no asymmetry of information. This is the agency cost of implementing a second-best contract in the presence of asymmetric information. Agency theory has found many applications in economics. Two illustrative examples are the consequences of the separation of control between shareholders and managers, and the delegation of taxation and ‘public good provision to states within a federation.
Reference: Oxford Press Dictonary of Economics, 5th edt.