Principal agent problem

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[edit]

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.

References[edit]

  • 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”
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