Principal-agent problem
Definition
Principal-agent problem: the conflict that arises when agents (managers) act in their own interest rather than that of the principals (owners), because of asymmetric information and the divorce of ownership from control.
Asymmetric information: a situation where one party, here managers, has more or better information than another, here owners, so decisions cannot be fully monitored.
- In large firms ownership is often divorced from control.
- Owners (principals) rely on managers (agents) to run the firm on their behalf.
- The problem arises when the two groups want different things and owners cannot fully observe what managers do.
- It matters because owners can end up worse off, with lower profit and dividends, than if they ran the firm themselves.
Key Idea
- The problem occurs when agents pursue their own aims rather than the principal's.
- It rests on asymmetric information, since managers know more than owners.
Divorce of ownership from control
- In a public limited company, shareholders own the firm but do not run it.
- Shareholders (the principals) delegate day-to-day decisions to managers (the agents).
- This separation of ownership from control is what creates the problem.
Note
- Small firms run by their owners face little or no principal-agent problem.
- The problem grows as firms get larger and ownership becomes more dispersed.
Differing objectives
- Owners want maximum profit, higher dividends and a rising share price.
- Managers may prefer a higher salary, status, perks or job security.
- Managers may pursue revenue or growth maximisation rather than maximum profit.
- These conflicting aims can leave owners worse off.
Example
- Suppose a chief executive is paid a fixed salary that does not depend on profit.
- The manager approves an empire-building takeover that raises their status but not returns.
- Shareholders receive lower dividends while the manager enjoys a larger firm to run.
- This shows the agent pursuing personal aims at the principal's expense.
Asymmetric information
- Managers know more about the day-to-day business than the owners do.
- Owners cannot fully monitor every decision managers make.
- This information gap lets managers pursue their own goals unnoticed.
Aligning owners and managers
- Performance-related pay ties managers' reward to profit or the share price.
- Share options give managers a direct stake in the firm's value.
- A board of directors and shareholder scrutiny monitor managers' decisions.
- The threat of takeover disciplines managers who neglect profit.
Key Idea
- Alignment tools such as share options narrow the gap but add cost and can push managers towards short-term profit at the expense of long-term innovation.
- So how far owners should monitor depends on the size and ownership dispersion of the firm; the divorce of ownership from control is the root cause of firms pursuing alternative objectives.
Can the principal-agent problem be solved?
- The problem can be greatly reduced: performance-related pay and share options tie managers' rewards to profit and the share price, aligning agents' incentives with owners' aims, while boards, shareholder scrutiny and the threat of takeover discipline underperforming managers.
- But it is rarely solved completely, because asymmetric information remains: owners still cannot observe every decision, and incentive schemes are costly and can push managers towards short-term profit that sacrifices long-term innovation.
- The size and ownership structure of the firm matter: in a small owner-managed firm the problem barely exists, whereas in a large public limited company with dispersed shareholders it is hardest to monitor.
- On balance, the problem can be contained rather than eliminated, so it depends on how well the firm designs incentives and monitoring relative to their cost and on how dispersed ownership is, since some residual conflict almost always remains where ownership is divorced from control.
Exam technique
- Name the principal and the agent clearly before explaining their conflicting aims.
- Tie the problem to asymmetric information and the divorce of ownership from control.
Common Mistake
- Do not describe the problem without mentioning asymmetric information.
- Do not assume managers always share the owners' objective of maximum profit.
Self review
- What is the divorce of ownership from control?
- Who are the principal and the agent in a public limited company?
- How does asymmetric information cause the principal-agent problem?
- Give two ways to align managers with owners.
