Principal-agent theory has been developed by economists to analyse employment contracts and particularly the employment contracts of senior executives. Since business owners cannot undertake the running of the organization entirely themselves, they must employ agents to act on their behalf (i.e. managers). However, the problem is that the interests of the agent are likely to differ from those of the principal (the business owner). The standard assumption is that employers want high levels of effort relative to pay, whilst all employees (including managers) want the reverse, though other assumptions may also figure. For example, that principals desire obedience, whereas agents value autonomy and independence. The principal-agent problem, therefore, is to minimize these differences of interest and secure an arrangement within the employment contract that maximizes the shared interests of the two parties. The typical recommendation that flows from this kind of analysis is that principals should adopt incentive schemes in order to control agents and ensure their interests are complementary to their own. For example, the theory is sometimes used to justify the payment of bonuses and the award of share options to senior executives, out of a belief that this will lead to shared interests and encourage executives to maximize shareholder value. [See executive pay.]
Subjects: Human Resource Management.