The Principal Agent Problem occurs when one person PDF

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The Principal Agent Problem occurs when one person (the agent) is allowed to make decisions on behalf of another person (the principal). In this situation, there are issues of moral hazard and conflicts of interest. The agent usually has more information than the principal. This difference in information is known as asymmetric information. The consequence is that the principal does not know how the agent will act. Also, he principal cannot always ensure that the agent acts in the principal’s best interests. This departure from the principal’s interest towards the agent’s interest is called an “agency cost.” In many real-world examples, the agent will not prioritize the best interest of the principal, but will instead pursue his own goals. Politicians (the agents) and voters (the principals) is an example of the Principal Agent Problem. A widespread real-life example of the principal agent problem is the way companies are owned and operated. The owners (principal) of a firm will elect a board of directors. The board of directors monitor and guide the management team like C-Level executives (the agents). More often than often, these agents will act in their own best interest. For example, greenlighting a massive project that gives them more authority or prestige instead of pursuing something else that could maximize shareholder value. “Too Big To Fail” is another example of the principal-agent problem. The idea behind too big to fail is that some companies become so significant and critical to the economy, that no matter what they do, the government will bail them out. This situation creates a moral hazard, where the agents have no incentive to do the right thing since they know they won’t be holding the blame at the end. This happened infamously during the Great Recession, where the American government bailed out companies and banks like AIG and JPMorgan Chase, two of which alone received nearly $100 billion in assistance from the federal government.

Solutions: Bonuses/ holding shares in the company Giving agents an incentive to maximize share value, instead of revenue growth aligning with the principal’s values. Ethical issue may arise as a result of this In Enron's case, the existence of the "agency problem" within its board of directors is partly to blame for the company's mismanagement and apparent unethical behaviour, say John Stephan and Harold Star, assistant professors of management science and systems, who are researching the role of boards and CEOs in setting corporate strategy. "The agency problem states that because top managers are typically not owners of a company, they can't be trusted to act in the best interest of those who do own the company -- the shareholders," says Stephan. "Boards of directors were seen as a solution to the agency problem because they have a legal responsibility to protect and serve the shareholders. "But what the Enron case illustrates is that the agency problem also exists within a company's board of directors," Stephan adds. "Boards, too, have incentives not to act in the best interest of shareholders."

"When the chairman is the CEO, then the nature of information that goes to the board is often distorted," says Star. "Making matters worse, the CEO typically stacks the board with cronies and supporters But what we're learning from Enron is that when board members own shares, there's a disincentive to ask the really tough questions for fear that those questions will drive down the stock prices Manipulating THROUGH BLACK OUTS. But what we're learning from Enron is that when board members own shares, there's a disincentive to ask the really tough questions for fear that those questions will drive down the stock prices

Long term contracts Employers are willing to offer secured income contracts because they can act as incentive mechanisms that motivate employees to put forth as much effort as they can so they can obtain the contract. Long-term contracts can be beneficial for both employers and employees. Employers benefit from being able to secure productive employees and prevent them from moving to the competition (Maxcy 1997), while employees, once they obtain a long-term contract, are promised a salary for a specific period of time. Principal-agent theory suggests that when parties of a contract have different objectives, shirking can occur. Monitoring shirking Can be difficult- there is a high transaction cost of obtaining information. Example of both: Apple requires ceos buy shares in the company for a number of years aswell as giving them extremely long contracts...