The Principal-Agent problem & Constrained Decision Making

By:- Shikha Shrivastava

Principal-Agent Relationship
The arrangement when one person (called as agent) acts on behalf of another company (called principal). For example, shareholders of a company (principals) elect management (agents) to act on their behalf, and investors (principals) choose fund managers (agents) to manage their assets . This arrangement works well when the agent is an expert at making the necessary decisions, but doesn't work well when the interests of the principal and agent differ substantially. In general, a contract is used to specify the terms of a principal-agent.

The Principal-Agent Problem

The principal-agent problem treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent such as the problem that the two may not have the same interests. Difficulty in monitoring manager on continual basis, goals other than profit maximization can be achieve. Managers may seek to enhance their positions by spending corporate funds on fancy offices, excessive & expensive travel etc.

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Managers may be given a basic salary plus potentially large bonuses for meeting goals as attaining a specified return on capital, growth in earnings, increase in price of firms stock. Manager is to receive an option to buy a specified no. of shares.

This option makes the manager a de facto owner.

Constrained decision making

Profit maximization is constrained by the limited information available to the manager. There are various constrained involve in decision making: Legal constrained: areas where managers seem to be having some legal difficulty include environmental laws, especially pollution, disposal of harmful wastes and employment laws.

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Moral constraints: They apply to action that are sufficiently inconsistent with generally accepted standards of behavior to be considered improper. Contractual constraints: They bind the firm because of some prior agreement such as long term lease, contract with union.

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Financial constraints: when a budget is assigned for next year and manager are given task to maximize the production to this amount.

Technological constraints: It limit on the amount of output per unit of time that can be generated by particular machines or workers.

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