What is “agency theory?” How can setting the appropriate goals for the firm minimize the agency problem?

Agency theory is a branch of economics that deals with principal-agent relationships. This relationship involves two parties, a principal and an agent, who have different sets of objectives and incentives that are not necessarily aligned. The principal (e.g., the stockholder) hires/employs an agent (e.g., a manager) to act on behalf of him or her in managing some asset or making decisions within the firm; however there can be a misalignment between their goals which can create an “agency problem” wherein the interests of one party may take precedence over those of another or the actions taken by one may conflict with those desired by another, resulting in inefficient outcomes for both parties.

Setting appropriate goals for the firm helps to minimize this potential agency problem as it ensures that all stakeholders involved have clear objectives and expectations which need to be met in order for everyone to benefit from the relationship. This includes proper management oversight whereby principals must monitor their agents’ performance while also incentivizing them through rewards when they achieve predetermined objectives; this serves as motivation for effective decision-making while rewarding productive behavior at work. Additionally, setting achievable goals gives managers a sense of purpose and accountability when carrying out their duties since they know what needs to be accomplished in order gain recognition from both superiors and peers alike.