Principal Agent Problem Short Answers

Here is a short video asking two questions on the principal agent problem.

Using an example, what is meant by the principal agent problem?

• The principal agent problem is an asymmetric information problem that stems from a divorce between ownership and control that is found in many businesses and other organisations
• The owners of a firm often cannot observe directly the day-to-day decisions of management.
• Decisions and performance of the agent can be costly and difficult to monitor accurately.
• Managers may have different aims and objectives than the owners of the firm. This creates the risk of a principal-agent problem.

Explain how a business might overcome the principal agent problem

• Employee share ownership schemes
  • John Lewis and Waitrose have a highly-regarded partnership model
• Long term employment contracts for senior management
  • Security of tenure might encourage managers to take decisions that are more aligned to 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
• Greater business transparency
  • Publication of detailed accounts and financial performance data - this might involve for example, real time information on sales available to all employees.
  • Criminal prosecutions of fraud within companies