Business and Technology · Governance in business organisations

Agency Relationship and the Agency Problem Explained

Updated 11 October 2026 · Fact-checked

An agency relationship exists when owners (principals) appoint managers (agents) to run a business for them. The agency problem arises because managers may pursue their own interests, not the owners'. Governance mechanisms such as monitoring, incentives and independent directors reduce this, but they create agency costs.

Understand Agency Relationship and the Agency Problem

In a small business the owner runs it. In a large company this is not possible. Shareholders own the company, but they hire directors and managers to run it day to day. This is the separation of ownership and control.

The owners are the principals. The directors and managers are the agents. The agent acts on the principal's behalf and is expected to act in the principal's interest. This is the agency relationship.

The agency problem (or principal-agent problem) is the conflict that appears when agent and principal want different things. Shareholders usually want long-term growth in shareholder wealth. Managers may want high pay, perks, job security, a bigger empire or less risk. Managers also know more about the business than shareholders do. This is information asymmetry, and it makes it hard for shareholders to see what managers are doing.

Typical symptoms include excessive pay and perks, empire building through poor acquisitions, focus on short-term profit to earn a bonus, avoiding risky but worthwhile projects, and manipulating reported results.

Companies try to align the two groups. They use monitoring, such as audits, an independent board and reporting. They use incentives, such as bonuses linked to performance and share options. Both create agency costs: the costs of monitoring, of bonding the agent, and any value still lost because the agent's decisions are not perfect. No mechanism removes the problem fully.

Key formulas to remember

Agency relationship: Principal (owner) appoints Agent (manager) to act on their behalf; In a company the shareholders are the principals and the directors are the agents.
Agency problem: Agent's own interests ≠ Principal's interests, plus information asymmetry; The conflict arises because managers control the business but do not bear the full cost of their decisions.
Agency costs: Agency costs = monitoring costs + bonding costs + residual loss; Monitoring: audits, reports, boards. Bonding: incentives and contracts. Residual loss: value still lost despite both.

How to solve Agency Relationship and the Agency Problem questions

Use this method for any question on agency, whether it is a definition, a scenario or a question on solutions.

1Identify the principal and the agent. In a company, shareholders are principals and directors or managers are agents.
2Check whether ownership is separated from control. If the owner also manages, there is little agency problem.
3Find the conflict in the scenario: pay, perks, risk, short-termism, empire building or hidden information.
4Name the cause: different goals, information asymmetry, or both.
5If the question asks for a solution, match it to the problem: monitoring, incentives, or board structure and disclosure.
6Remember that every solution has a cost. Mention agency costs if the option fits.
7Check each option against the exact wording and choose the one that best fits.

Quickest way: Who, what conflict, what fix

When to use it: Use for two-mark objective test questions where you have about a minute per question.

Underline the two parties. Owners are principals, managers are agents.
Decide if the action benefits the agent at the owners' expense. If yes, it is an agency problem.
For fixes, think: watch them (monitoring), reward them (incentives), or appoint independent directors.
For multiple response, select only options that clearly link to agent behaviour or a control on it.
Eliminate options about customers, employees or government unless the question is about other stakeholders.

Common mistakes in Agency Relationship and the Agency Problem

Reversing principal and agent.
Managers seem powerful, so students think they are in charge.
Fix: Owners appoint managers. The one who appoints is the principal; the one who acts is the agent.
Saying agency problems exist in every business.
Students learn the theory without its condition.
Fix: The problem needs separation of ownership and control. A sole trader who runs their own business has little or none.
Treating agency costs as losses caused only by dishonest managers.
The word 'cost' suggests a loss from bad behaviour.
Fix: Agency costs include the money spent to prevent the problem, such as audit fees and monitoring, as well as value lost.
Assuming bonuses and share options fully solve the problem.
They look like a perfect link between manager and owner.
Fix: They can encourage short-termism or manipulation of results. Say that they reduce the problem but do not remove it.
Confusing the agency problem with stakeholder conflict generally.
Both involve conflicting interests.
Fix: Agency is specifically owner versus manager. Stakeholder conflict covers many groups such as employees, customers and lenders.

Worked examples

Example 1

The board of a listed company agrees to buy a business in an unrelated industry. Analysts say the price is too high, but the chief executive's pay is linked to company size. Which agency problem does this show? A) Information asymmetry only B) Empire building C) Bonding cost D) Residual loss on audit

Show the solution

Principals are the shareholders. The agent is the chief executive.
The agent gains because pay rises with size, even though the deal may reduce shareholder wealth.
This is a manager pursuing own interest through growth for its own sake.
Option A is incomplete. Option C and D are agency costs, not a behaviour.

Answer: B) Empire building

Example 2

Explain two ways a company can reduce the agency problem between shareholders and directors, and state one drawback of each.

Show the solution

Method 1: link director pay to performance, such as share options or bonuses tied to profit or share price.
This aligns directors' wealth with shareholder wealth, so they have a reason to increase it.
Drawback: it can encourage short-term focus or manipulation of the reported results to earn the bonus. It also costs money.
Method 2: appoint independent non-executive directors and an audit committee to monitor management.
This gives shareholders independent scrutiny and reduces the information gap.
Drawback: monitoring has a cost, and non-executives may know less about the business than executives.

Answer: Performance-linked pay aligns interests but may cause short-termism and manipulation. Independent non-executive monitoring improves scrutiny but adds cost and may be limited by their knowledge. Both are agency costs, and neither removes the problem completely.

Exam tips

Start every scenario by naming the principal and the agent. It usually points to the right option.
Learn the typical symptoms: excess pay and perks, empire building, short-termism, risk aversion and hidden information.
For solution questions, group answers as monitoring, incentives and board or disclosure, and mention the cost.
In multiple response questions, read the number of options you must select and do not choose generic stakeholder answers.
Watch for wording like 'best' or 'most likely'. Several options may be partly true.

Practice questions from Governance in business organisations

Agency Relationship and the Agency Problem in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Agency Relationship and the Agency Problem: frequently asked questions

What is the agency problem in simple terms?

Owners hire managers to run a company, but managers may act in their own interest instead. The owners cannot easily see everything managers do. That gap in goals and information is the agency problem.

What are agency costs?

Agency costs are the costs of dealing with the agency problem. They include monitoring costs such as audits, bonding costs such as incentive schemes, and any value still lost from imperfect decisions.

How can a company reduce agency problems?

It can monitor managers through audits, independent directors and reporting. It can also align interests through performance-related pay and share options. Each method has a cost and limits.

Who are the principal and agent in a company?

Shareholders are the principals because they own the company. Directors and managers are the agents because they act for the shareholders. In theory the agent should act in the principal's interest.