Agency Relationships

Question 1

What is a Agency Relationship?

Answer 1

An “Agency Relationship” is a contract under which one or more persons (the principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. In our case, the principal are investors and the agents are the managers of the firms in which they invest.

Question 2

What are agency problems?

Answer 2

• Adverse selection – agent no longer makes best decision for principal but makes the decision which will appear best to principal (given principal’s imperfect knowledge) whilst actually serving private interests of agent
• Moral hazard – agent knows that their actions cannot be monitored and will act in their own best interest irrespective of whether this is optimal for principal