Principal agent problem

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Principal-agent-problem or agency-problem has a long history and dates back to the time when persons or entities tired to maximise their personal interest. The problem appears when one person or entity, normally known as the agent, is allowed to make decisions on behalf of another person, normally known as the principal. This situation provides the perfect foundation for issues of moral hazard and conflicts of interest. The principal usually has less information than the agent what is also known as asymmetric information. In consequence of that the principal can not be fully aware of the agents behaviour. Also, it is not guaranteed that the agent always acts in the principal's best interests. This lack between the principal's and the agent's interest is called agency cost. In many examples, the agent will not prioritize the best interest of the principal but will instead pursue his own goals.

In finance, management and economics the agency-problem can categorised into three different types:

The first type is related to the problem because of information asymmetry and different understanding of risk-taking. The second typ of problem arise due to the fact major owners take decisions for their own benefits at the expense of the minor owners. The third typ of conflict could be described as a problem that the owner is likely to take more risky investment decisions against the will of the creditors.

Principal-Agent-Problem Examples

The Problem is broad enough that it can be found in different academic fields like accounting, finance, economics, management, political science or marketing:

  • In economics, principal-agent-problems occurs because of different understanding of risk-taking. A person or entity is likely to take more risks because someone else carries the cost of those risks. For example, some people take more risks like to go base jumping if they have a health insurance, because they know someone else is responsible and will pay if they are injured.
  • In finance the problem appears between companies (principal) and rating agencies who were hired to set a credit rating. A low credit rating will increase the cost of borrowing for the company. The Company has an incentive to structure its compensation of the rating agency so that they will get a higher rating. The rating agency don't want to lose future business relations, so they are less likely to be objective when it comes to examine the company's credit rating.

Advantages of Principal agent problem

One of the advantages of the Principal-agent problem is that it gives people a way to delegate work and trust that it will be done according to their wishes. This problem also provides incentives to the agent to do their job more efficiently and with more care. Furthermore, the principal-agent problem allows for more efficient decision making, as the principal can delegate decision-making responsibility to the agent. This can help to reduce the time needed for making decisions, or it can provide the principal with the benefit of the agent’s expertise. Additionally, the principal-agent problem can reduce the burden of the principal, as the agent can take over some of their work. Finally, the principal-agent problem can help to reduce costs, as the agent is often paid a commission or fee for their work.

Limitations of Principal agent problem

Principal-agent problem, or agency-problem, is a fundamental issue in economics and business, as it represents an inherent conflict of interest between the principal and the agent. It is important to ensure that proper regulations and incentives are in place to ensure the agent acts in the best interests of the principal. However, there are several limitations to the principal-agent problem which include:

  • The principal’s preferences are difficult to measure: The principal’s preferences are subjective, and can be hard to define and measure. This makes it difficult to assess whether or not the agent is acting in the best interests of the principal.
  • Adverse selection: Adverse selection occurs when the agent has more information than the principal, which can lead to suboptimal decisions being made.
  • Moral hazard: Moral hazard occurs when the agent is not held fully accountable for their actions, which can lead to the agent taking unnecessary risks or shirking responsibility.
  • Imperfect information: Imperfect information can make it difficult for the principal to accurately assess the actions of the agent, leading to suboptimal decisions.
  • Incentive misalignment: If the incentives for the principal and the agent are not aligned, then the agent may not be motivated to act in the best interests of the principal.

Other approaches related to Principal agent problem

In addition to the traditional approach to Principal agent problem, there are several other approaches that have been developed to address the issues of moral hazard and conflicts of interest.

  • Contract Theory: Contract Theory proposes that the principal and agent enter into a contract, which outlines the expected behavior of both parties. This theory recognizes that the principal and agent have incentives to behave in ways that are not in the best interest of the principal, and thus creates a framework to ensure that the interests of both parties are taken into account.
  • Agency Theory: Agency Theory is a relatively new approach to the Principal agent problem and focuses on the relationship between the two parties. It suggests that the agent should act in the best interests of the principal, but also acknowledges that the agent has their own goals and objectives.
  • Transaction Cost Economics: Transaction Cost Economics deals with the costs associated with doing business. It suggests that the behavior of the principal and agent should be determined by the costs associated with the transaction.
  • Incentive Theory: Incentive Theory is an approach to the Principal agent problem that focuses on providing incentives to the agent to encourage them to act in the best interests of the principal. The incentives can take the form of financial rewards or non-financial rewards, such as recognition or praise.

In summary, there are several different approaches to the Principal agent problem that have been developed to address the issues of moral hazard and conflicts of interest. These include Contract Theory, Agency Theory, Transaction Cost Economics, and Incentive Theory. Each of these approaches has its own merits and can be used to ensure that both the principal and the agent are acting in the best interests of the organization.

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  • N. Shah, Sunit; 2014: Title "The Principal-Agent Problem in Finance"
  • Gay, Sebastian and Denning, Chris S.; 2014: Title "Corporate Governance Principal-Agent Problem: The Equity Cost of Independent Directors"
  • Panda, Brahmadev and Leepsa, N. M.; 2017: Title "Agency theory: Review of Theory and Evidence on Problems and Perspectives" in Indian Journal of Corporate Governance
  • Foss, Nicolai J.; 2013: Title "Agency Theory - SMG Working Paper No. 7/2013"