Principal-Agent Problems
Friday, October 3, 2008 11:10
The term of the agent refers to the management team, while the term of principal refers to the shareholders of a company. For examples, the investors of a company will be the principals while the elected managers of various hierarchies in different departments of the company are the agents. Usually, to specify the terms of a principal-agent relationship, a contract is used.
The Principal-Agent Problem is also called as agency dilemma. It is a particular game-theoretic description of a situation. The problem comes into being when incomplete and asymmetric information during the process of a principal hiring an agent. In political science and economics, it is usually found in most relationships between the employer and employee.
The classical example in economics is the potential conflict of interest between ownership and management. The underlying assumption is that the interest of the agent may vary from the ones of the principal in the companies, such as in piece rates or commissions, profit sharing, efficiency wages, performance measurement including financial statements, the agent posting a bond, or the fear of firing.
According to agency theory, there are two types of problems:
1) The agency problem that arises when the goals of the principals and agents conflict, and it’s difficult or expensive for the principal to verify what the agent is actually doing.
2) The problem of risk sharing arises when the principal and the agent have different attitudes and preferences toward risk.
Various mechanisms may be adopted to align the interests of both parties and reduce the ‘problem’.
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