Principal-agent theory

Principal-agent theory

According to Eisenhardt (1989) the terminologies “principal” and “agent” have their basis in law. He is f the opinion that of all the contracts drafted in the world, these two terms must feature prominently. This is due the risks, uncertainties and imbalances that occur in the world. The theory involves the dynamics that ensure that the agent receives adequate motivation to ensure they work for the principal. A good example of this relationship is the one that occurs between employers and employees. The employer has to ensure that they provide the employee (agent) with the necessary stimulation for them to get their work well done (Eisenhardt, 1989).

Principal-agent theory

According to Bebchuk & Fried (2004) a perfect example could be that of a patient (principal) who goes to see his dentist (agent). The patient is faced with the dilemma of whether the prescription given by the dentist is the proper one, or the dentist is just out to milk more money from him. The relationship is said to be asymmetrical in that the dentist knows more than the patient. The patient can thus not ascertain that whatever the dentist if offering him is the right thing or not. A case then presents in that, for the patient to get whatever they need they have to undergo a cost that may be painful to them. The dentist,on the other hand, will have to undergo some costs to ensure that the patient gets the right treatment.

Some of the terms that come out in this relationship include; agency cost. This is the sacrifice the agent has to make to meet the expectations and needs of the principal. There are different ways through which the interests of these two parties can be aligned so that there is the minimal conflict of interest. For instance, in the case of an employer and employee, the employer can use improved salaries to boost the employees’ work. On the other hand, the employee (agent) may be driven by the fear of losing a job to boost their productivity. This article will tackle some inherent areas of concern as regards this theory.

First, the article shall tackle the application of this theory in the drafting of employment contracts. These contracts form give and take between the employer and the employee. It is in this document that the employer outlines and restructures the incentives, employee benefits and what they ought to do in order to reap these benefits. These contracts vary depending on several aspects that include; the ability of the employee to maneuver themselves around their jobs and capability to bear and withstand risk s associated with the work. Some of the things that make the contracts different include; the amount of bonuses awarded, salaries and the mode of sharing profits (Eisenhardt, 1989).

 The mode of compensation varies with the type of job that one does. For instance, those doing sales most earn their compensation in term of bonuses and commissions. Others like casuals work and get paid per the hours they have worked. Most of the business owners have come up with the strategy of giving tips to their workers in an attempt to win their hearts. This is mainly meant to make the employer and employee read from the same script as regards the success of the establishment/ business. This is believed will yield the fruits of better customer service from the staff. The driving force for excellent performance is the anticipation of the tips. As much as tipping may be beneficial to the business if not checked it may ride the business into making losses. This may be in the case where the employee gives customers large servings in anticipation of tips (Eisenhardt, 1989).

Secondly,Prendergast C (1999) is of the opinion that each individual has a particular level of inner satisfaction that he derives from the work he does. He further thinks that pegging the performance or morale of the workers on monetary compensation may lower their productivity. The reason advanced for this is that, the employees will not see the need to go an extra mile to make their work perfect in the absence of incentives.

The third aspect that can bring out the meaning of this theory clearly is the concept of working as a team to realize the organizational goals. The proponents of this are of the opinion that if the employees are made to work as individuals, the aspect of team work will be killed and consequently lowering the performance of the organization. The impact of failed teamwork can be pronounced in situations where cooperation is needed (Eisenhardt, 1989).

 According to Alchian and Demsetz (1972), in an organization with team work, the employees are paid on the basis what the group produces. The weakness with this approach is that some of the employees will tend to ride on the good work of their coworkers. This eventually leads to diminished performance by the individual workers. This in the long run leads to increased operational costs and reduced work output. In conclusion, this theory is applicable in many circumstances in life where there is a mutual relationship (Rosen, 1986).


Bebchuk, L,. & Fried, J., (2004).  Pay Without Performance. Harvard University Press

Eisenhardt, K. (1989). .Agency theory. An assessment and review, Academy of

 Management Review, 14 (1): 57-74.

Pendergast, Canice (1999). “The Provision of Incentives in Firms”.Journal of

 Economic Literature 37: 7–63.

Rosen, S. (1986).Prizes and Incentives in Elimination Tournaments, American

 Economic Review, 76, 4, 701-715.

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