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Study Notes

Explaining the Principal Agent Problem

AQA, Edexcel, OCR, IB

Last updated 18 Mar 2023

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

The principal-agent problem arises when the interests of a company's owners (the principals) are not aligned with those of its managers (the agents) who make decisions on their behalf. This can lead to conflicts of interest, as managers may prioritize their own goals over the objectives of the company's owners. Here are three ways corporations can help overcome this problem:

  1. Align incentives: One way to align the interests of managers and owners is to offer incentives that are tied to the company's performance. For example, executives may be given stock options or performance-based bonuses that depend on the company's profitability, growth, or other key metrics. This gives managers a direct stake in the success of the company and can motivate them to make decisions that benefit shareholders.
  2. Increase transparency: Transparency can help mitigate information asymmetry between managers and owners. By providing regular reports and disclosures on the company's operations and financial performance, owners can monitor the decisions made by managers and ensure they are acting in their best interest. For instance, a corporation can make its financial statements available to the public, hold regular meetings with shareholders, or provide detailed disclosures on executive compensation.
  3. Appoint independent directors: Independent directors who do not have ties to management can act as a check on the decisions made by managers. They bring an outside perspective and can provide oversight to ensure that management is acting in the best interest of shareholders. For instance, a corporation can appoint a board member who has no prior relationship with the company or its executives and who has expertise in the relevant industry or field.

By adopting these measures, corporations can help mitigate the principal-agent problem and ensure that managers act in the best interest of their owners.

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