What issue does agency theory examine and why is it important in a public corporation rather than in a private corporation?

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Agency theory, when one party (the principal) hires another party (the agent) to perform a task the principal is unable or unwilling to do, is based on the premise that both parties are motivated by self-interest. Therefore, they each will do what they need to further their own interests in the partnership. The term used for the difference between the best possible outcome for the principal and the consequences of the work of the agent is called agency loss. When the principal’s and agent’s interests are aligned, the agency loss is zero. However, when the agent’s interests conflict with the principal’s interests, the principal may lose profits. Private corporations often offer incentives to the agent to prevent agency loss. Public corporations are governed by more regulations and bureaucratic processes. They are often unable to offer incentives and may be greatly impacted by agency loss.

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Agency theory essentially says that whenever one person or group of people (called the principals) hires another person or group (the agents) and gives them authority to make decisions, conflicts can arise.  The conflicts can arise when the interests of the principals and those of the agents are not perfectly aligned with one another.  Agency theory, then, examines the conflicts of interest that can arise between principals and agents.  This is much more likely to be a problem in a public corporation than in a private one.

The problem addressed in agency theory typically arises when stockholders hire managers to run their company.  The personal best interests of the manager may not be the same as the best interests of the stockholders.  This problem is minimized in a private company.  In a private company, the owners are generally the managers or are very closely tied to the managers.  Therefore, there is not the same potential for conflict between the principals and the agents.

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