Principal Agent Problem

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. 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. uring 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.

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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 information and differences in sensitivity to firm-specific risk.

Conflicts of interest between controlling and minority shareholders may arise because the controlling shareholders, much like controlling managers, can divert part of the firm’s resources for their own private benefit at the expense of non-controlling shareholders. In the case of managers, these private benefits may take the form of excessive perquisites, such as corporate jets and lavish headquarter building, or of self-aggrandizing rules without adding value to shareholders, or of delaying necessary restructuring decisions to avoid unpleasant confrontations with employees, unions, politicians and the media.

Firms are a nexus of contracts among individual factors of production (Alchian and Demsetz 1972). (Ross 1973). An agency relationship exists within all contractual agreements. In general, an agency relationship can be defined as being one when the principals hire an agent(s) to take decisions and actions on their behalf (Ross 1973, Jensen and Meckling 1976). Economic theory states that individuals want to maximize their own wealth. If directors did pursue their own interests, such as short term profit enhancing projects or sales, than this is in conflict with shareholders interests which is to maximize wealth in the long term.

Therefore it can be argued that directors are behaving opportunistically. In addition, directors have historically been labeled as being risk-averse (Buck et al 2003) individuals because their capital is largely human capital, and may be of little value outside the specific organization in which they were promoted (Coffee, 1988; Castanias & Helfat, 1991). (Gray and Cannella 1997). Further to this point, when firm performance is poor, executives risk the loss of their jobs and much of their earnings potential (Coughlan & Schmidt, 1985; Gilson, 1989; Cannella, Fraser & Lee, 1995). Gray and Cannella 1997). In contrast, shareholders are described as risk neutral (Buck et al 2003), 4 because they are able to eliminate unsystematic risks through portfolio diversification- this is the basis of portfolio theory (Markowitz 1952). (Arnold 2005). Overall, the domain of agency theory are relationships that mirror the basic agency structure of a principal and an agent who are engaged in cooperative behavior, but have differing goals and attitudes towards risk (Eisenhardt 1989). (Shankman 1999).

This leads to the principal agent-problem. 1. 2 Agency costs To resolve the agency problem, agency costs must be incurred. Jensen and Meckling (1976: 308) identified three agency costs. The first cost is the expenditure by the principal to monitor the agents (monitoring prevents shirking (Besanko et al 1996)) and establish appropriate incentives, such as linking pay to performance of the company. In doing this, the principal is able to promote efficiency and reduce the principal-agent problem.

The second cost, is the cost incurred by the agents to show that they are acting in the best interests of the shareholders or that shareholders are compensated for their actions. For example, the agents will produce annual reports showing full details of the investments they undertook, the costs incurred and the profits made for the financial year. 5 The third and final cost is ‘residual loss’ (p. 308). This is incurred when the agents diverge from the principals’ interests. This is arguably the most prominent problem that exists in the principal-agent relationship.

As all the events/ contingencies cannot be identified in the contract due to bounded rationality, directors end up with the residual rights of control, giving them enormous latitude for self interested behaviour (Shleifer and Vishny 1997). In some cases this results in the director taking highly inefficient actions, which costs investors far more than personal benefits to the manager (Shleifer and Vishny 1997). Therefore corporate governance matters when transaction costs and incomplete contracts (Sinha 2006) are present.

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