Principal-Agent: Theory and Problem

2021-05-25 23:53:37
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Case study
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The problem that arises as a result of motivating one party ( the agent) so as to act on behalf of another (the principal) is generally considered as the principal-agent problem or in most instances the agency problem in short. There are various contexts that the principal-agent problem may arise for instance when a lawyer is meant to act in the best interest of their clients when managers are supposed to act in the best interest of their employees, shareholders and even when politicians are supposed to represent their voters.

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The problems of agency normally arise when the incentives between the principal and the agent are not perfectly aligned thereby leading to an increase in the conflict of interest. Due to the misaligned interests, an agent may be tempted to act in their own interest rather than the interest of the principal. In these situations, the conflicts of interest are almost inevitable. Various explanations can be used to depict why agents can get away with not acting in the best interest of the principal.

One of the most likely explanation is that the cost that the principal endures of punishing the agent or removing the agent is too high in relation to the benefit that the agent gets. A good example is in the instance of politicians and voters. A corrupt politician may be able to get away with corruption during their time in office since in some circumstances it may be too costly for the electorate to take action as they are highly dispersed. The second reason to explain the existence of the principal-agent problem is the presence of information asymmetry. Information asymmetry is as a result of one party (the agent), having access to more information or is better informed than the other party(the principal). Instances of informational asymmetry almost make it impossible for the principals to know whether their agents are acting in their best interest. What makes it even more challenging is when certain crucial variable such as the competence of the agent or effort of the agent are not observable. This thus means that in order for the principal-agent relationship to be problematic in any instance, two ingredients should always be present. These ingredients include private information and conflicting incentives.

At the start of the third industrial revolution, there was more awareness about the principal-agent problem. There are many theories that can be attributed to the increase in awareness. However, most of the theories are based on the economic climates at the third industrial revolution. The third industrial upheaval was based on the concept of shifting renewable energy and new communications technologies that were used to integrate the new energy systems. The new communications systems that had been put in place made it possible to manage the new complex commercial activities that arose because of the third industrial revolution.

The principal-agent problem became more exposed during the third industrial revolution since employers needed to respond to the agency problems. Most of the employers achieved this feat by ensuring that they increased the monitoring of their employees. Initially, this was achieved through enhanced management scrutiny of employees at the workplace. This, however, was not very successful as it necessitated a significant investment of the resources of the employer and their time. This means that there was a need to ensure that a strategy that aligned the interest of the employees with that of the employers had to be formulated. Employers were able to achieve this feat by ensuring that they tied their employees with compensation-based don the productivity or the performance of the organization. This was mainly done through contracts, and this ensured that there was an increased awareness of the principal-agent problem. The instances that the agents were not highly motivated turned immensely during the third industrial revolution as the managers of large firms were offered stock options. The stock options were part of the compensation packages of managers and employees. As the stock prices value rose, so did the value of the companies.

Due to the mindset of the principal-agent problem, the aims of most companies in the third industrial revolution were the maximization of the market value. However, this was not always compatible with the interests of the managers as most of them preferred to maximize their own personal interests and in most instances, this was done at the expense of the owners of the company (Kistruck, 2013).

One of the key negatives of this mindset is that there was an increased instance of conflicts of interest between the shareholders and the managers. The problem existed despite the right of the shareholders (principal) to manage the organization through participating in, and voting during the meetings of the organizations. Managers, on the other hand, preferred greater levels of consumption and at the same time less intensive work. This was because these factors did not decrease the value of the shares of the company that they also owned. The second negative is that managers tended to prefer short-term investment horizons. This is a negative, as it does not give the company vision to work towards in the future. Once a particular manager is out of their job or is sacked then all the ambitions of that company are likely to go with the sacked manager.

The third negative aspect of principal agent mindset adoption is that managers in most companies tend to increase the size of the companies that they manage even if the action that they take to harm the interests of their shareholders in addition to their remuneration and prestige since these two factors are positively correlated with the size of the company. Moreover, these inclinations by the managers tend to cause conflicts of interest among the managers who tend to value the expansion of the company and one the other hand the shareholders who are more oriented towards the maximization of the value of their shares in the company. The only positive in this instance is that if there are sufficient internal funds, then managers may be motivated to undertake investments that are of dubious profitability and this would, in turn, lead to rejection by the capital markets.

The principal-agent problem mindset also leads to the increase in the quality and the quantity of information in the marketplace that is related to the behavior of the agent. This meant that there were increased levels of management, establishment of control systems, physical surveillance. Although these problems were supposed to control the problems raised by the asymmetry of information, it is often impracticable to solve such problems.

It is imperative to comprehend that although options such as surveillance may in most instances raise privacy issues that do not always paint the correct picture of the organization, it raises some issues to deal with transparency that anyone in the organization may be willing to tackle. Consequently, the problems of moral hazards and adverse selection that depict fixed remuneration contracts do not in all instances depict the ideal solutions to organize relationships that exist between agents and their principals (Vining & Richards, 2016).

In conclusion, there are various contexts that the principal-agent problem may arise for instance when a lawyer is meant to act in the best interest of their clients when managers are supposed to act in the best interest of their employees, shareholders and even when politicians are supposed to represent their voters (Boynton et al., 2015). Instances of informational asymmetry almost make it impossible for the principals to know whether their agents are acting in their best interest. What makes it even more challenging is when certain crucial variable such as the competence of the agent or effort of the agent are not observable. Due to the mindset of the principal-agent problem, the aims of most companies in the third industrial revolution were the maximization of the market value.

The problems of agency normally arise when the incentives between the principal and the agent are not perfectly aligned thereby leading to an increase in the conflict of interest. Due to the misaligned interests, an agent may be tempted to act in their own interest rather than the interest of the principal. , these inclinations by the managers tend to cause conflicts of interest between the managers who tend to value the expansion of the company and one the other hand the shareholders who are more oriented towards the maximization of the value of their shares in the company.

References

Boynton, W., Blosick, G., & Rainish, R. F. (2015). The principal agent problem, tracking error, and the optimal investment portfolio. Applied Economics Letters, 22(3), 239-246. doi:10.1080/13504851.2014.934429

Vining, A. R., & Richards, J. (2016). Indigenous economic development in Canada: Confronting principal-agent and principalprincipal problems to reduce resource rent dissipation. Resources Policy, 49358-367. doi:10.1016/j.resourpol.2016.07.006

KISTRUCK, G. M., SUTTER, C. J., LOUNT JR., R. B., & SMITH, B. R. (2013). MITIGATING PRINCIPAL-AGENT PROBLEMS IN BASE-OF-THE-PYRAMID MARKETS: AN IDENTITY SPILLOVER PERSPECTIVE. Academy Of Management Journal, 56(3), 659-682. doi:10.5465/amj.2011.0336

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