Principal Agent Problem

Topics: Principal-agent problem, Agency cost, Asymmetric information Pages: 3 (941 words) Published: August 4, 2011
One problem in assuming that businesses set price and output to maximise profits is that decision-taking where there is a divorce between ownership and control can be difficult to monitor. How do the owners of a business know that managers making the key day-to-day decisions are operating to maximise shareholder value? This lack of information is known as the principal-agent problem. In other words, one person, the principal, hires an agent (e.g. a sales or finance manager) to perform tasks on his behalf but he cannot ensure that the agent performs them in precisely the way the principal would like. The decisions and the performance of the agent are impossible and or expensive to monitor and the incentives of the agent may differ from those of the principal. Examples of the principle-agent problem that have hit the financial headlines include the management of financial assets on behalf of investors (e.g. Equitable Life) and the management of companies on behalf of shareholders (e.g. during the turbulent years experienced by Marks and Spencer). Another example drawn from the public sector might be the efficient and effective running of public services such as education, health and transport in the UK by private firms under regulation by government authorities There are various strategies available for coping with the principal agent problem. One is the rapid expansion of employee share-ownership schemes. Ryan Air one of Europe’s fastest growing low-cost airlines offered its pilots a share-scheme for the first time in January 2001. The deal entails a 15% rise in basic pay over five years for the more than 220 pilots as well as the share options and a productivity agreement. A second option in offsetting the principal agent problem is the introduction of other variants of performance-related pay or long-term employment contracts for senior management. Agency problems between shareholders and management usually arise from a combination of asymmetric...
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