Investor's wiki
en English
Navigation
Home Glossary
InvestingStocksBondsCryptoPersonal FinanceFundamental AnalysisTechnical AnalysisTradingBankingTaxes
Disclaimer Terms of Use Privacy Policy Cookie Policy
Navigation
Home Glossary
InvestingStocksBondsCryptoPersonal FinanceFundamental AnalysisTechnical AnalysisTradingBankingTaxes
Disclaimer Terms of Use Privacy Policy Cookie Policy

Principal-Agent Problem

Principal-Agent Problem
BusinessBusiness Essentials

What Is the Principal-Agent Problem?

The principal-agent problem is a conflict in needs between a person or group and the representative authorized to act for their sake. A agent may act in a way that is in opposition to the best interests of the principal.

The principal-agent problem is just about as fluctuated as the potential jobs of principal and agent. It can happen in any situation in which the ownership of an asset, or a principal, designates direct control over that asset to another party, or agent.

Grasping the Principal-Agent Problem

The principal-agent problem has turned into a standard factor in political science and economics. The theory was developed during the 1970s by Michael Jensen of Harvard Business School and William Meckling of the University of Rochester. In a paper distributed in 1976, they illustrated a theory of an ownership structure intended to stay away from what they defined as agency cost and its objective, which they distinguished as the separation of ownership and control.

This separation of control happens when a principal hires an agent. The principal designates a degree of control and the right to go with choices to the agent. In any case, the principal holds ownership of the assets and the liability for any losses.

For instance, an organization's stock investors, as part-owners, are principals who depend on the organization's chief executive officer (CEO) as their agent to carry out a strategy to their greatest advantage. That is, they believe the stock should increase in price or pay a dividend, or both. In the event that the CEO selects rather to furrow every one of the profits into expansion or pay big bonuses to managers, the principals might feel they have been let down by their agent.

There are a number of solutions for the principal-agent problem, and a considerable lot of them include explaining expectations and monitoring results. The principal is generally the main party who can or will address the problem.

Agency Costs

Consistently, the principal can't continually monitor the agent's actions. The risk that the agent will evade a responsibility, settle on a poor choice, or in any case act in a way that is in opposition to the principal's best interest can be defined as agency costs. Extra agency costs can be incurred while dealing with problems that emerge from an agent's actions. Agency costs are seen as a part of transaction costs.

Agency costs may likewise incorporate the expenses of setting up financial or different incentives to urge the agent to act with a certain goal in mind. Principals will bear these extra costs as long as the expected increase in the return on the investment from hiring the agent is greater than the cost of hiring the agent, including the agency costs.

Answers for the Principal-Agent Problem

There are ways of settling the principal-agent problem. The onus is on the principal to make incentives for the agent to act as the principal needs. Consider the principal model, the relationship between shareholders and a CEO.

The shareholders can make a move before and subsequent to hiring a manager to defeat some risk. In the first place, they can compose the manager's contract in a manner that adjusts the incentives of the manager to the incentives of the shareholders. The principals can require the agent to report results to them consistently. They can hire outside monitors or auditors to follow data. In the most pessimistic scenario, they can supplant the manager.

Contract Clauses

In recent years, the trend has been towards employment contracts that associate compensation as closely as conceivable with performance estimations. For managers of businesses, incentives incorporate performance-based awards of stock or stock options, profit-sharing plans, or directly connecting management pay to stock price.

At its root, it's a similar principle as tipping for good service. Hypothetically, tipping adjusts the interests of the customer, or the principal, and the agent, or the server. Their needs are presently adjusted and are centered around great service.

Instances of the Principal-Agent Problem

The principal-agent problem can crop up in numerous everyday situations past the financial world. A client who hires a legal counselor might worry that the legal advisor will wrack up additional billable hours than are needed. A homeowner might dislike the City Council's utilization of taxpayer funds. A home buyer might think that a realtor is more interested in a commission than in the buyer's interests.

In these cases, the principal has no real options. An agent is important to take care of business.

Features

  • The problem can happen generally speaking, from the relationship between a client and a legal counselor to the relationship among stockholders and a CEO.
  • The principal-agent problem is a conflict in needs between the owner of an asset and the person to whom control of the asset has been designated.
  • The risk that the agent will act in a manner that is in opposition to the principal's best interest can be defined as agency costs.
  • Settling a principal-agent problem might require changing the system of rewards to adjust needs or working on the flow of data, or both.