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Fundamentals of Business Economics and Management · Stewardship Theory and Agency Theory of Management

Meaning and Concept of Agency Theory in Management

Updated 10 October 2026 · Fact-checked

Agency theory explains the relationship between a principal (the owner) who hires an agent (the manager) to act on the owner's behalf. Ownership and control are separated, and both sides may pursue their own interests. This creates conflicts of interest, called the agency problem. In MCQs, spot the principal, the agent and the conflict.

Understand Meaning and Concept of Agency Theory

Start with a simple case. You own a business but cannot run it every day. So you hire a manager and give them power to take decisions. You are the principal. The manager is the agent. This arrangement is the principal-agent relationship.

In a small firm, the owner and manager are often the same person. In a large company, thousands of shareholders own the firm but cannot manage it. They appoint directors and managers to do it. This is the separation of ownership and control. Owners hold the shares. Managers hold the day-to-day decision power.

Agency theory starts from one assumption: people act mainly in their own self-interest. Shareholders want higher profit and rising share value. Managers may want a higher salary, perks, job security, power or a bigger empire. These goals do not always match.

This mismatch is a conflict of interest, and the problems it causes are the agency problem. It is made worse by information asymmetry: the manager knows far more about the business than the owner does. So the owner cannot easily check whether the manager is working in the owner's best interest.

The theory therefore views management as a contract-based relationship that needs monitoring and incentives. It takes a cautious view of managers, which is why it is usually contrasted with stewardship theory, which trusts them.

Key formulas to remember

Principal-agent relationship
Principal (owner) → delegates authority → Agent (manager)
The principal hires the agent to act on their behalf and take decisions.
Source of the agency problem
Separation of ownership and control + self-interest + information asymmetry = conflict of interest
All three together create the agency problem. Remember this as the cause chain.
Core assumption
Agent's goals ≠ Principal's goals
Agency theory assumes individuals are self-interested and goals may diverge.

How to solve Meaning and Concept of Agency Theory questions

Use this method for any MCQ on the meaning and concept of agency theory.

  1. 1Read the question and find who owns the business and who runs it.
  2. 2Label the owner (shareholder) as the principal and the manager or director as the agent.
  3. 3Check whether the question is about meaning, cause or conflict.
  4. 4If it is about cause, look for separation of ownership and control or information asymmetry.
  5. 5If it is about conflict, look for the agent's own interest (perks, salary, power) against the owner's interest (profit, wealth).
  6. 6Eliminate options that describe trust, shared goals or stewardship, as these do not fit agency theory.
  7. 7Pick the option that matches the self-interest assumption.

Quickest way: Principal, agent, conflict check

When to use it: Use it for one-line definition or identification MCQs when time is short.

  1. Ask: who owns? That is the principal.
  2. Ask: who manages? That is the agent.
  3. Ask: are their goals different? If yes, it is agency theory.
  4. Reject any option saying managers always act in the owner's interest.

Common mistakes in Meaning and Concept of Agency Theory

  • Treating the manager as the principal and the shareholder as the agent.

    Students think the manager is in charge, so must be the boss.

    Fix: The principal is whoever delegates authority. Shareholders delegate to managers, so managers are agents.

  • Confusing agency theory with stewardship theory.

    Both deal with owners and managers, and the names look alike.

    Fix: Agency theory assumes self-interest and conflict. Stewardship theory assumes managers act as responsible custodians.

  • Saying the agency problem arises only in large companies.

    Textbook examples mostly use listed companies.

    Fix: It can arise wherever one person delegates decisions to another. It is just most visible when ownership and control are separate.

  • Ignoring information asymmetry as a cause.

    Students remember only conflict of interest.

    Fix: Remember that agents know more than principals, which makes monitoring hard and conflict easier.

  • Thinking agency theory says all managers are dishonest.

    The self-interest assumption is read too strongly.

    Fix: The theory says managers may pursue their own interests when goals differ. It is an assumption for analysis, not a claim about every manager.

Worked examples

Example 1

Shareholders of a listed company appoint a board and a CEO to run it. The CEO spends heavily on luxury offices, which lowers profit. In agency theory, the shareholders are called: (A) agents (B) principals (C) stewards (D) auditors

Show the solution
  1. Shareholders own the company and delegate decisions.
  2. The one who delegates authority is the principal.
  3. The CEO who acts on their behalf is the agent.
  4. Stewards belong to stewardship theory, and auditors are not part of this relationship.

Answer: (B) principals

Example 2

Which of the following best explains why an agency problem arises? (A) Managers and owners always share the same goals (B) Ownership and control are separate and the goals of the two may differ (C) Managers own all the shares (D) Profits are always distributed fully

Show the solution
  1. The agency problem needs a conflict of interest.
  2. Option A says goals are the same, so there is no conflict. Reject it.
  3. Option C means owner and manager are the same, so there is no separation. Reject it.
  4. Option D has no link to conflict between owner and manager.
  5. Option B states separation plus different goals, which is the cause.

Answer: (B) Ownership and control are separate and the goals of the two may differ

Exam tips

  • Learn the three labels first: principal is the owner, agent is the manager, and the problem is the conflict of interest.
  • When an option says managers always act for owners' benefit, treat it as a stewardship idea and eliminate it.
  • Look for keywords: self-interest, separation of ownership and control, information asymmetry, delegation.
  • There is no negative marking, so answer every question even if you are unsure after elimination.

Practice questions from Stewardship Theory and Agency Theory of Management

Meaning and Concept of Agency Theory in other exams

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

Meaning and Concept of Agency Theory: frequently asked questions

What is agency theory in simple words?

It studies the relationship between owners (principals) and managers (agents) who act for them. It says the two may have different goals. This can lead to conflicts of interest.

Who is the principal and who is the agent in a company?

Shareholders are the principals because they own the company. Directors and managers are the agents because they run it on the shareholders' behalf.

What is the agency problem?

It is the conflict that arises when an agent acts in their own interest instead of the principal's. It is helped along by separation of ownership and control and by the agent's better information.

Is agency theory the same as stewardship theory?

No. Agency theory assumes self-interested managers and needs monitoring and incentives. Stewardship theory assumes managers act as responsible custodians of the owners' interests.