There is separation between ownership & control in most of the firm that we see today. As owners, shareholders appoint managers to make decisions for the company. There is another term to describe relationship between them. Shareholders are the PRINCIPAL that appoints the manager (AGENT) to act on the shareholders’ behalf so that profit can be maximize. E.g.
Principal & agent are 2 different parties. With that, different objectives are likely to occur. In the case of shareholders & managers, shareholders wants to maximize profit but managers may want to maximize sales, their prestige, status, comfort, etc. The problems between the shareholders & managers can be illustrated by 2 economic concepts: Adverse Selection
I. Adverse Selection
Shareholders need to appoint managers to run their company. For this, shareholders will conduct an interview to invite potential managers to take up the job. During interview, shareholders face difficulty. There is lots of hidden information which the shareholders do not know—Ability to manage company, conduct of the person, effort that the person will put in, character, objective of the managers. There are ways to reduce this HIDDEN INFORMATION problem: Shareholders may require managers to provide information on their educational background, references from previous employment, a list of past achievements Thus, the shareholders are able to evaluate the managers better. Despite all the steps, shareholders can never get full information about the managers. II. Moral Hazard
When the manager is appointed, the shareholders face a different problem. Shareholders are unable to observe all the actions & decisions taken by the managers. A manager may use...