Finance

Principal-Agent Problem

Principal-Agent Problem

The principal-agent problem is a conflict in the needs of an individual or group and the agent approved to follow up on their behalf. This problem arises when an individual (agent) makes decisions on behalf of another person (the principal). An agent may act in a manner that is in opposition to the best interests of the principal. This problem is as varied as the potential roles of principal-agent. It can happen in any situation where the responsibility for resource, or head, assigns direct power of the asset to another party, or agent. The agent does not prioritize the best interest of the principal in many real-world scenarios but rather pursues his own interests.

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Types of agency problems:

  • Stockholders v/s Management: Ownership in a company is isolated from management. Stockholders cannot actively engage in management for this purpose. The duty or duty of management is on the part of a professional manager. Often proficient managers, without regard to the interest of the shareholder, give priority to their own interest. As a result, conflicts of interest are generated between management and stockholders.
  • Stockholders v/s Creditors: Creditors want to see owners pay principal and interest in a timely manner. However, if a reasonable amount of profit is not made by the venture, the owners are not prepared to pay the creditors’ claims on their own profits. Hence, conflict occurs as a result.
  • Stockholders v/s Stakeholders: The shareholder wishes to profit entirely from the assets. On the other hand, manufacturers, customers, employees, and other parties want a raise in salaries, high-quality goods at reduced costs, prompt payment of bills, etc. As a result, the shareholder’s interest is hindered.

Causes and Consequences:

The primary causes behind this issue are conflict of interests between two parties and false information between them. The principal-agent problem generally results in agency costs that the principal has to bear. And because agents can act in their interests at the principals’ expense, this problem is an example of Moral Hazard. The principal-agent problem was conceptualized in 1976 by the American market analysts, Michael Jensen and William Meckling. It has applications in political theory and financial aspects. It is important in terms of corporate administration.

The principal-agent problem is also an indicator of market failure. Market failures occur when there is a misallocation of resources resulting in market distortions.  This distortion causes market inefficiency. A market failure is triggered when the agent pursues his own interest rather than that of the principal, which causes a business inefficiency.

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Example:

The principal-agent problem can occur in numerous everyday circumstances beyond the financial world. In human society, several principal-agent relationships can be identified., such as doctors and patients, shareholders and managers, managers, and staff. A customer who appoints a lawyer may stress that the attorney may charge more billable hours that are required. A homeowner may disapprove of the City Council’s use of taxpayers’ funds. A homebuyer may suspect that the realtor is more interested in commission than in the buyer’s concern.

One of the key issues that occur in organizations is asymmetrical information between principals and agents where owners and managers have different attitudes towards the objective. Managers may have data that is not fully available to owners, which will make it possible for managers to make choices in their own interests. Also, the conflict between shareholders (as principals) and managers (as agents) is a good example of the principal-agent problem. In all the above cases, the principal has little choice in the matter. So, an agent is necessary to get the job done. However, there are solutions to this problem.

Solutions:

Solutions to the principal-agent problem aim to align the interests of both parties. One method is Contract Design, main purpose of this is the creation of a contract framework between the principal and the agent to address issues of information asymmetry, stimulate the agent’s incentives to act in the best interests of the principal. Another method is Performance evaluation and compensation, the compensation of the agent should be according to his/her performance. Tying the agent’s compensation closely to the benefits obtained for the principal helps to eliminate conflict of interest.

 

Author – Priyanshu Ahuja

About the author – I’m a first-year student from City Premier College, Nagpur, pursuing BBA. My interest includes financial markets and investment domain.

 

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