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RUNNING HEAD: THE PRINCIPAL-AGENT PROBLEM

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The principal-agent problem

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Introduction

The principal-agent problem is an emerging issue in the contemporary business often

incorporated in Agency theory. Agency theory is the relationship amid the owners (principals)

who delegates power and duties to agents (managers) who act on the owners’ behalf. A perfect

of example of the principal agency problem is well explained by the relationship amid the

managers and shareholders of any organization especially those that are traded publicly. A

contract exists amid the two parties with

performance measures and goals clearly stipulated.

The principals delegate keeping in mind that agents act in their best interests. It is, however, hard

to accomplish this, as both the owners and managers hold conflicting interests, with the results

maneuvered by managers to depict distorted facts. Most managers shun risks and responsibilities

which results in moral hazard. The moral hazard aspects and disparities of interests arise, when

an agent, employed by the principal to undertake stipulated duties does not hold the principal’s

best interests because of high costs involved. The alignment of interests of the principal and the

agent is the source of the problem amid the two parties as it is difficult to synchronize the

interests. Agents receive incentives from the principals because of the existence of risks and

information asymmetry to enable the agent to complete a contract effectively with the principal’s

interests at heart.

Conflicts between owners and managers

Agency theory highlights the elementary problem of the self-interested behavior in an

organization. The organization’s manager may hold individual’s goal that compete with the goals

of the owner. The goal of the owners of a firm is mainly wealth maximization. With

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authorization from the shareholders, managers oversee the organization’s assets, hence the

impending conflict of interests amid the two parties.

Self-interested behavior

Agency theory proposes that managers will opt to maximize their personal utility rather

than corporate shareholders interests in case of imperfect capital and labor markets. Asymmetric

information is a situation where agents have more information than the shareholder does on

relevant issues. The information could be on whether or not they have the capacity to attain the

objectives set by the shareholders and the underlying uncertainty. This asymmetric information

gives the managers an opportunity to operate in a way that maximizes their utility in place of the

owners’ interests. Proof of the managerial behavior exhibiting self-interest includes spending the

organization’s resources in perquisites form and optimal risk situation evasion. In this case,

managers who are risk averse avoid profitable opportunities that shareholders would prefer to

make investments. External investors note that the organization makes decisions divergent from

their best interests (McEachern, 2012). Consequently, the investors reduce the prices of the

firm’s securities they are willing to pay.

A probable agency conflict materializes whenever the proportion of the firm’s common

share owned by the manager is less than 10 percent. For a sole proprietorship where the business

is owned and managed fully by the owner, the manager conducts business in a way that

maximizes her or his personal welfare. In this scenario, the owner manager is likely to measure

utility by individual wealth and maybe even foregoes other considerations like perquisites and

leisure for personal wealth. When the owner manager trades off his fraction of his or her

ownership of the corporation by trading of their common stock to external investors, then agency

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conflict occurs. For instance, the preference of the owner manager might be a relaxed lifestyle

with no rigorous work involved in the maximization of shareholders wealth as less of this wealth

amasses to the owner manager. Furthermore, the owner manager may opt to increase the

consumption of perquisites, as the benefits’ consumption costs is borne by the outside

shareholders.

Agency conflicts are substantial in most of the corporations, which are publicly traded

and large, as the organization’s manager owns a petite proportion of the entire common stock of

the company (McEachern, 2012). It is likely that maximization of stockholders’ wealth will

subordinate a variety of management goals’. For example, the manager’s objective may involve

maximizing the firm’s size. Through the development of a large, fast growing organization, the

executive enhance their own status, and increase the opportunities for managers in the lower and

middle capacities and their remunerations, in order to promote their job security avoiding the

hostile takeover. Consequently, the incumbent management seeks to enhance diversification at

the cost of the owners who can comfortably spread their personal portfolios through purchase of

shares in other firms.

Punishments, incentives and constraints, are some of the ways through which managers

are propelled to act in the best interests of the owners of the firm. However, these methods are

material and efficient only if the owners keenly keep track of the managers’ actions. The

problem of moral hazard occurs with the agents undertaking in unobserved activities, promoting

their individual interests, as it is infeasible and difficult for the owners to supervise all

managerial activities. In an attempt to trim down the problem of moral hazard, the shareholders

are compelled to contend with the agency costs.

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Costs of the owner-management conflict

Agency costs are costs incurred by the owners to allure the managers to conduct business

in a way that maximizes the shareholders interests, as opposed to fulfilling their utilities. There

are three key agency costs, which include expenses to monitor the actions of the management

like audit costs. The second cost is the structuring expenses, which limit detrimental managerial

behavior in the organization, or restructuring expenses of management hierarchy, and the firm’s

business units or employment of the external board of directors’ members. Lastly, the

opportunity costs borne from restrictions, which are shareholder imposed like stockholders

votes’ requirement on certain matters or restrict the managers’ capacity to undertake activities

that promote the wealth of the stockholders.

Some loss will be incurred on shareholders wealth from improper managerial activities if

there are no efforts to modify the behavior of the management. Alternatively excess agency costs

would occur when the stockholders try to make certain that all the managerial actions are in line

with the interests of the owners. From the two extreme cases, the levels of optimal agency costs

incurred by shareholders are established using a cost- benefit analysis. The agency should only

be increased provided each additional dollar incurred leads to at least a proportional dollar

increase in the wealth of the shareholders; otherwise, the agency costs should be reduced or

maintained at its current level.

Mechanisms for handling shareholder-manager conflicts

Dealing with agency conflicts amid the shareholder and the manager take two extreme

positions. One polar position entails the compensation of the firm’s managers wholly based on

prices on the stock prices. For this scenario, level of agency costs incurred is low as managers

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hold immense inducements in shareholders’ wealth maximization. It is almost impossible to

employ any talented and qualified executives under these contractual conditions, as the earnings

of the firm are influenced by the economic events, which are beyond the managerial control of

the executive. Another polar position involves the stockholders monitoring all the action of

management and this solution is inefficient and extremely costly. Consequently, the most

favorable solution falls between the two polar positions with the executive reparation tied to their

performance, although controlled level of monitoring of managerial actions is also suitable.

Apart from monitoring, the following approaches also persuade mangers to conduct business in

the interests of the shareholders: stockholders’ unswerving intervention; the risk of hostile

takeover, the threat of dismissal and incentive plan tied on the performance.

Currently, most firms that are publicly traded have adopted the use of performance shares

where executives are awarded using stock shares based on their performance. This reward is

stipulated by the financial measures, which incorporate return on assets (ROA), variations in

stock prices, return on equity (ROE), and earning per share (EPS). The managers of the firms

earn more shares when the firm’s performance exceeds the set performance targets, and they get

fewer shares with the performance below the set targets. Compensation plans, which are

incentive based like the mentioned performance shares, are formulated to meet two objectives.

Foremost, shareholders provide executives to compel the executive undertake activities that

promote the wealth of shareholders. Secondly, these plans enable organizations to attract and

retain executives with adequate confidence to sacrifice their financial future based on their own

capabilities resulting to improved performance.

In corporate America, investors that institutionally based like mutual funds, pension

funds and insurance companies own a greater proportion of common stock. The institutional

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fund managers have the influence, which can be willingly put forth substantial pressure over the

operations of the firm. These institutional investors can manipulate the executives of the firms in

two key ways. First, they can convene a meeting with management of the firm and propose

suggestions concerning the operations of the organization. Second, the institutional stockholders

can propose a suggestion to be voted on at the stockholders’ annual meeting regardless of

management’s opposition. The proposals sponsored by these stockholders’ kind mostly entail

issues outside daily operations and are nonbinding, hence significantly manipulating opinion of

the management (McEachern, 2012).

Historically, the probability of the management of a large corporation being overthrown

by its shareholders posed insignificant threat as it was remote. This was possible as most firms’

ownership was distributed extensively with a considerable control of the management through

voting, making it difficult for the owner to gather necessary votes requisite to remove the sitting

executive. This has changed with time as institutions are increasingly investing in the market for

equities and because of their large amounts of funds; they own significant proportion of firms.

A hostile takeover by rival companies competing in a similar line of business takes place

in cases of inadequate management. The managers of the companies never intend to sell the firm,

but the takeover possibly occurs when the stocks of the firm is undervalued in comparison to its

standard or potential value. Prior to takeover, the company is always at the verge of collapse and

almost bankrupt, although there are fewer cases where the government steps in, and saves the

dying company. An example is the case of General Motors in the U.S. bailed out financial

difficulty by the Obama’s government. In some cases, large shareholders, as the institutional

investors threaten to pull out and this preempt a hostile takeover. In the cases of hostile takeover,

the senior management of the firm under acquisition is discharged of their duties. However, the

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individuals retained lose the independence they enjoyed before the acquisition. Managerial

behavior is disciplined through hostile takeover threat prompting the executive to try to

maximize the value of the stockholders. The thought of losing a job or the position held is an

incentive that addresses the problem associated with the agency theory.

Conclusion

In the contemporary world, it is common for businesses and individuals to appoint an

individual to act on their behalf mostly because of the expertise of the agent. Therefore, the

problem between principal and agents is inevitable. It is impossible to appoint an agent who will

fully serve the interests of the principal as both parties hold divergent interests that cannot be

synchronized. Most agents hold more information their principal because of their qualifications,

which are the reasons for their services being sought, and the fundamental cause of the agency

conflict. It is impossible to solve the agency conflict, but there are mechanisms that are

employed to reduce the effects of this problem considerably. The goal of these mechanisms is to

streamline the action of agents so that there is a close relationship between their actual and

expected actions. This narrows the gap amid the management action and the realization of the

interests of the principals.

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Reference

McEachern, W. A. (2012). Microeconomics: A contemporary introduction. Mason, OH: South-

Western Cengage Learning.