tutor2u | Principal Agent Problem

Study Notes

Principal Agent Problem

Level:
A Level
Board:
AQA, Edexcel, OCR, IB

Last updated 13 Aug 2021

The principal agent problem is an asymmetric information problem. It comes about because owners of a firm often cannot observe directly easily and accurately the key day-to-day decisions of management.

Principal(s) are owner(s) of the business with a significant equity stake

  • They hire an agent such as a sales or finance manager to make day-to-day decisions affecting the business
  • Managers may have different business objectives such as revenue maximization or sales maximisation

Overcoming the Principal Agent Problem

What is in the best interest of the management is not necessarily the same as the optimum interests of shareholders. Most strategies involve trying to align the aims of these different stakeholders.

  • Employee share ownership schemes:
    • For example, John Lewis and Waitrose have a well-regarded partnership model.
    • Another example, in 2019, the founder of Richer Sounds, handed over control of the firm to his staff.
    • However, offering stock options might lead to perverse behaviour among employees – for example, deliberate attempts to hike up share prices through illegal action (think back to the notorious case of the US energy company Enron).
  • Long term employment contracts for senior management:
    • Security of tenure might encourage managers to take pricing and investment decisions in the long-term best interests of the business rather than for short-term profit.
  • Long term stock commitment:
    • Apple requires senior executives at Apple Inc. to hold three times their annual base salary in stock, and executives must keep this salary in stock for a minimum of five years to satisfy the requirement.
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