Study notes

Principal Agent Problem

  • Levels: A Level
  • Exam boards: AQA, Edexcel, OCR, IB, Other, Pre-U

How do the owners of a large business know that managers work to build shareholder value? This lack of information is known as the principal-agent problem or the “agency problem".

Divorce between Ownership and Control

Ownership and control

The owners of a private sector company normally elect a board of directors to control the business's resources for them. However, when the owner sells shares, or takes out a loan or bond to raise finance, they may sacrifice some of their control.

Other shareholders can exercise their voting rights, and providers of loans often have some control (security) over the assets of the business

This may lead to conflict between them as different stakeholders can have varying objectives.

The Principal Agent Problem

How do the owners of a large business know that managers work to build shareholder value? This lack of information is known as the principal-agent problem or the “agency problem".

The principal agent problem revolves around how best to get your employees to act in your interests rather than their own?

Shareholders tend to want strong returns in the form of dividend payments and a rising share price.

Managers may have objectives such as power, bonuses, large expense accounts, prestige and status. The problem is the many shareholders have no day-to-day control over managers.

Pension fund managers cannot dictate what CEOs and CFOs of businesses decide to do and senior executives may have little knowledge of what their managers are doing.

Many investors are 'passive'. The biggest investors in UK-listed companies tend to be large institutional shareholders such as pension funds and insurance companies.

What is in the best interest of the management is not necessarily the same as what is in the best interests of the shareholders. Strategies involve trying to align the interests of these two different stakeholders.

Employee share ownership schemes

  • John Lewis and Waitrose have a highly-regarded partnership model
  • Stock options might lead to perverse behaviour – e.g. deliberate attempts to hike up share prices through illegal action (think back to the case of Enron)

Long term employment contracts for senior management

  • Security of tenure might encourage managers to take decisions in the long term best interests of the business

Long term stock commitment

  • Apple’s new policy (2013) requires senior executives at Apple to hold three times their annual base salary in stock, and executives have to keep this salary in stock for a minimum of five years to satisfy the requirement

Key terms

Agency problem

Possible conflicts of interest that may result between shareholders (principal) and the management (agent) of a firm

Stakeholders

In most businesses there are many different stakeholders. These include customers, managers, employees, shareholders, debt holders and the government

Stakeholder conflict

Stakeholder conflict occurs when different stakeholders have different objectives. Firms have to choose between maximizing one objective and satisfactorily meeting several stakeholder objectives, so called satisficing

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