Principal-Agent Problem

Principal-Agent Problem

What is the main agent problem?

The principal-agent problem is a conflict of priorities between a person or a group and the representative authorized to act on their behalf. An agent may act contrary to the best interests of the principal.

The principal-agent problem is as varied as the possible roles of the principal and the agent. It can occur in any situation in which the ownership of an asset or a principal delegates direct control of that asset to another party or agent.

Key points to remember

  • The principal-agent problem is a conflict of priorities between the owner of a property and the person to whom control of the property has been delegated.
  • The problem can arise in many situations, from the relationship between a client and a lawyer to the relationship between shareholders and a CEO.
  • Solving a principal-agent problem may require modifying the rewards system to align priorities or improve the flow of information, or both.

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What are the main agent issues?

For example, a company’s equity investors, as co-owners, are executives who rely on the company’s chief executive officer (CEO), like their agent, to carry out a strategy in their best interest. In other words, they want the stock to go up in price or pay a dividend, or both. If the CEO chooses to spend all the profits on expansion or to pay big bonuses to managers, managers may feel that they have been disappointed by their agent.

There are a number of remedies for the principal-agent problem, and many of them are to clarify expectations and monitor results. The principal is usually the only party who can or correct the problem.

Understanding the principal-agent problem

The principal-agent problem has become a standard factor in political science and economics. The theory was developed in the 1970s by Michael Jensen of Harvard Business School and William Meckling of the University of Rochester. In an article published in 1976, they laid out a theory of a property structure designed to avoid what they defined as the cost of agency and its cause, which they identified as the separation of ownership and control. .

The trend is towards contracts with the agent which link remuneration directly to the performance measures set by the client.

This separation of control occurs when a principal hires an agent. The principal delegates a certain degree of control and the right to make decisions to the agent. But the principal retains ownership of the assets and responsibility for any loss.

Taking into account agency fees

Logically, the principal cannot continuously monitor the agent’s actions. The risk of the agent shirking responsibility, making a wrong decision or acting in a manner contrary to the best interest of the principal can be defined as agency fees. Additional agency fees may be incurred when dealing with issues arising from an agent’s actions. Agency costs are considered to be part of transaction costs.

Agency fees may also include the costs of setting up financial or other incentives to induce the agent to act in a particular way. Directors are willing to bear these additional costs as long as the expected increase in the return on investment from hiring the agent is greater than the cost of hiring the agent, including agency fees.

Examples of the principal-agent problem

The principal-agent problem can arise in many situations beyond the financial world. A client who hires a lawyer may worry that the lawyer will work more billable hours than necessary. A homeowner can disapprove of the use of taxpayer funds by city council. A buyer may suspect that a real estate agent is more interested in a commission than in his concerns.

In all these cases, the school principal has little choice in the matter. An agent is required to do the job.

However, there are ways to resolve the principal-agent problem.

Solutions to the principal-agent problem

It is the responsibility of the principal to create incentives for the agent to act as the principal wishes. Take the first example, the relationship between shareholders and a CEO.

Shareholders can take steps before and after hiring a manager to overcome certain risks. First, they can draft the manager’s contract in a way that aligns the manager’s incentives with the shareholders’ incentives. Directors may require the officer to report results regularly to them. They can hire monitors or external auditors to monitor the information. In the worst case, they can replace the manager.

Contract clauses

In recent years, the trend has been towards employment contracts which link remuneration as closely as possible to performance measures. For business executives, incentives include the allocation of shares or stock options based on performance, incentive plans or a direct link between management compensation and the share price .

At its root, it’s the same principle as tipping for good service. Theoretically, tipping aligns the interests of the client or principal and the agent or server. Their priorities are now aligned and focused on good service.

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