Agency Theory (AT)

Question 1

Quickly explain Agency Theory

Answer 1

Uses the metaphor of a contract to describe
relationships in which one party, the principal,
delegates work to another, the agent.

Question 2

What problems do the principal encounter?

Answer 2

1. Pre-contractual problem (during relationship initiation): Hidden information/Adverse selection
2. Post-contractual problem (after the relationship is
   established) : Hidden action/Moral hazard

Both problems are rooted in information asymmetry

Question 3

What is hidden information?

Answer 3

Potential partners may lie/misrepresent their abilities and motivation.

Question 4

How to overcome hidden information?

Answer 4

• Screening
When it is “easy” to evaluate agents (e.g., inspection, talk to customers, etc..)
• Examine signals from agents
It must be most costly for agents that do not have the characteristics needed (e.g., up-front investments)
• Provide opportunities for self-selection
Expensive pre-qualification process (e.g., certification)

Question 5

What is hidden action?

Answer 5

Partner may cheat/shirk and behave contrary to the principal’s goals.

Question 6

How to overcome hidden action?

Answer 6

Strategies to reveal agent’s behavior:
• Monitor and reward outcomes (output)
• Monitor and reward behavior (input)
• Third-party monitoring of outcomes and/or behavior