Principal Agent Problem Short Answers
- A-Level, IB, BTEC National
- AQA, Edexcel, OCR, IB, Eduqas, WJEC
Last updated 21 Mar 2021
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