What is a Principal-Agent Problem?

This can create potential losses and undesirable situations for the principal. One primary reason for this conflict is the asymmetric distribution of information between the principal and agent, i.e., the person hired to manage the assets holds more information than the owner of the assets, resulting in an information gap.

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Key Takeaways

  • The principal-agent happens when the agent hired by the principal to work in his best interests decides to act in his own self-interest, creating challenges to the client.It can cause monetary losses for the client, operational challenges, market failures, and diminish the trust between the two parties.A real-life example can include CEOs or insurance agents catering to their own interests instead of the shareholders or clients.Solutions to this problem include structuring a strong contract, incentives and penalties through performance analysis and reducing the information gap.

Principal Agent Problem Explained

The Principal-agent problem can appear whenever there’s a conflict of interest between a person (the principal) and someone who should be working in that person’s interest (the agent), but they’re not. The agent decides to maximize their own benefit instead of the client.

The situation was first studied back in the 1970s. At the time, the economic theorists Michael Jensen and William Meckling reunited to publish a paper that discussed the structure of this concept which they called the ‘agency theory. They argued that the nature of the relationship between the owner and their contractual relationships defines the firm’s expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more. They also talk about the information asymmetry and uncertainty that causes the principal-agent problem in corporate governance.

Essentially, the principal-agent is an optimal relationship where the principal delegates its authority to an agent for solving an issue. The agent then makes decisions to help the principal. The principal retains the ownership of all the assets involved in the transaction or business, but he gives the agent the right to manage them, hoping to get the best result.

However, that circle can be broken with a conflict of interest. Instead, the agent gets the assets and uses them on behalf of their interest instead.

Reasons

The person hiring the agent does not know whether this person will work on their behalf or not. But supposedly, they trust them. However, they do not know the field as well as the agent. Nor do they possess the degree of information the agent does. Therefore, it makes it harder for them to determine if they came up with the best solution. As a result, the principal depends on the agent by taking a leap of faith.

An agent may start to look out for their best interest for a variety of reasons. It can vary from unethical professional objectives to improper incentives or a lack of moral conduct from the principal’s side. The owner might not be sticking to the contract or earning way more than they claim to be. At the same time, they may not be compensating the agent enough. Both parties will always look after their own interests had there been no proper alignment of roles. Conflicts of that sort are common among board membersBoard MembersBoard members comprise the individuals whom the shareholders elect as their representatives. They are responsible for taking crucial corporate decisions regarding the company’s policies, dividend payouts, top-level managers’ recruitment or layoff and executive compensation.read more and shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company’s total shares.read more, trusteesTrusteesA trustee is an individual or institution with legal authority to manage the trust property and assets on behalf of the settlor to benefit the beneficiary. They have complete control over the trust assets until they get transferred to the beneficiary. The administration of assets goes as per the directions of the trust. read more and beneficiaries, etc.

Consequences

The principal will inevitably face some challenges due to the acts of self-interests by the agent. It can be monetary losses or operational challenges for the firm. The principal-agent problem in corporate governance can also cause a market failureMarket FailureMarket failure in economics is defined as a situation when a faulty allocation of resources in a market. It is triggered when there is an acute mismatch between supply and demand. As a result, prices do not match reality or when individual interests are not aligned with collective interests.read more, which is the faulty allocation of resources. Instead of using their resources most profitably, the principal will lose some of it by hiring a service that won’t provide what is needed.

It not only affects the person who is losing money because of the agent but it diminishes the overall efficiency of the whole market. In addition, the client will incur agency costsAgency CostsIt is common for shareholders’ to disagree with the business manager’s approach of operating business to maximize wealth. When such a situation arises, the costs incurred to resolve the conflict and restore harmony are referred to as Agency Cost.read more, which increase the costs of using that specific service and make them less attractive.

Another consequence is the erosion of trust in a certain industry. Services and people who do not deliver as promised often tarnish their reputations. It can have a huge impact on the long-term economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more of a certain industry, for example

Real-Life Pricipal Agency Problem Example

We can use a few real-life examples to illustrate how these situations may happen. For instance, let’s say that a technology company decides to hire a new CEO. He was chosen for this position because he’s an important figure in the media, and the shareholders believe that he will bring value to their shares.

After a few months on the job, however, the CEO discovers that it may be more profitable to act in his own interest instead of ensuring that the company is profitable. For example, the CEO could decide to focus on projects that would keep him in the spotlight, maximizing his own image instead of the value that the shareholders get.

They can’t monitor what he’s doing all the time, so they may lose a lot of money until they discover that the CEO is consciously not acting in their interests.

Another example could be seen when someone wants to buy insurance. They can’t do it alone, so they need to look for an agent. However, this agent may want to help himself more than the customer and pick a plan that gives him a higher commission, not the best service.

In this case, the person would be losing money when they could have used a better service if they had more information about the plans.

Principal-Agent Problem Solution

Fortunately, there are ways to solve this problem. 

#1 – Structuring a Strong Contract

A strong contractual agreement is necessary to pay groundwork for seamless business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company’s goals like profit generation.read more. The contract must be detailed, thorough, and inclusive of incentives, performance evaluation, and compensation. It should also list out procedures to oversee all regulatory measures. 

#2 – Evaluating the Performance

One can create mechanisms that will evaluate agents’ performance based on their decisions. If the agents do well following these criteria, they will receive a reward. However, if it’s clear that the agents are acting only in self-interest, they may get sanctions. Periodical performance evaluations, for instance, are excellent solutions.

For example, shareholders could write a contract in which the CEO that they’re hiring will be rewarded for acting in a way that benefits them, such as making the price of the shares go up. Similarly, the contract could have some clauses which would affect the CEO negatively if it’s proven that he’s working against the shareholders. However, to prove this, they would still need to know how their work is going, which is not always possible, so the reward for good behavior is still important.

#3 – Increasing Awareness

This has been a guide to Principal-Agent Problem and its meaning. Here we explain how it works along with its consequences, examples & solution. You may learn more about financing from the following articles –

The principal-agent problem arises when there is a conflict of interest between the owner (principal) and the person hired to manage their assets(agent). The agent, who holds more information about asset management, can make decisions that benefit him at the expense of the principal’s welfare.

It can be solved by proper performance evaluation, allotting adequate incentives and penalties, and fixing the information asymmetry.

Stockholders enlist the best managers to do the job but may not be willing to pay them adequate wages and benefits as this decreases the shareholders’ income. The managers who are often more familiar with the field than stockholders may take decisions that reward them solely. Managers and stockholders should align their goals towards the welfare of both parties for the successful running of a co-operation.

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