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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.

Short Answers - 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

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