A P P E N D I X B

Agency Theory

The figures and text in this appendix are adapted from Murthy and Jack (2014),
pp. 85–86, with the permission of Springer.

Warranty Fraud Management: Reducing Fraud and Other Excess Costs in Warranty and Service Operations.
Matti Kurvinen, Ilkka Töyrylä and D. N. Prabhakar Murthy
© 2016 by Matti Kurvinen, Ilkka Toyryla, and D.N. Prabhakar Murthy. Published by John Wiley & Sons, Inc.

343
A
gency theory attempts to explain the relationship that exists
between two parties (a principal and an agent) where the princi-
pal delegates work to the agent, who performs that work under a
contract. This is exactly the case where one is looking at service agent
fraud. The warranty provider is the principal delegating the warranty
servicing to a service agent.
Agency theory is concerned with resolving two problems that can
occur in principal–agent relationships. The first issue arises when the
two parties have conflicting objectives, and it is difficult or expensive
for the principal to verify what the agent is actually doing and whether
the agent has behaved appropriately. The second issue is the risk shar-
ing that takes place when the principal and the agent have different
attitudes to risk (due to various uncertainties). Each party may prefer
different actions because of their different risk preferences.
The different issues that are involved in agency theory are indicated
in Figure B.1 and discussed briefly in this appendix.1

Moral hazard
This refers to the agent’s possible lack of effort in carrying out the
delegated tasks and the fact that it is difficult for the principal to
assess the effort level that the agent has actually used.

Risk
This results from the different uncertainties that affect the outcome
of the relationship. The risk attitudes of the two parties may differ,

Costs

Monitoring Incentives
Principal

Contract
Risk performance Information asymmetry

Agent

Moral hazard Adverse selection

Figure B.1 Issues in agency theory

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and a problem occurs when they disagree over the allocation of

the risk.

Monitoring
The principal can counteract the moral hazard problem by closely
monitoring the agent’s actions.

Costs
Both parties incur various kinds of costs. These will depend on
the outcome of the relationship (which is influenced by various
types of uncertainty), acquiring information, monitoring, and on
the administration of the contract.

Incentives
This refers to the means through which the principal can motivate
and influence the behavior of the agent. Incentives can be either
positive (reward) and/or negative (penalty).

Information asymmetry
The overall outcome of the relationship is affected by several
uncertainties, and the two parties will generally have different
information to make an assessment of these uncertainties.

Adverse selection
This refers to the agent misrepresenting their skills to carry out
the tasks and the principal being unable to completely verify this
before deciding to hire them. One way of avoiding this is for the
principal to contact people for whom the agent has previously
provided service.

Contract
The key factor in the relationship between the principal and the
agent is the contract that specifies what, when, and how the work
is to be carried out and also includes incentives and penalties for
the agent. This contract needs to be designed taking account of all
the issues involved.

NOTE
1. For more on agency theory, see Eisenhardt (1989) and van Ackere (1993).