3.1.1 Significance of the divorce of ownership from control: the principal-agent problem:

Question 1

Definition of Principal-Agent Problem

Answer 1

Explanation: This problem arises when the interests of the owner (principal) and the manager (agent) of a firm do not align, leading to conflicts.

Question 2

Misaligned Incentives:

Answer 2

Point: Managers may prioritize personal gain over maximizing shareholder wealth.

Example: CEOs receiving large bonuses even if company performance declines, leading to shareholders losing value.

Question 3

Risk Aversion:

Answer 3

Explanation: Managers may avoid taking risks that could benefit the firm but endanger their job security.

Example: Managers may resist long-term investments in research and development due to the uncertainty involved.

Question 4

What are the solutions to the principal-agent problem?

Answer 4

To align the interests of managers (agents) with shareholders (principals), companies use:

• Performance-based pay: Stock options or bonuses tied to company performance.
• Monitoring: Regular checks and oversight by the Board or shareholders.
• Corporate governance: Ensuring rules and practices guide the company effectively and ethically.
  These mechanisms help reduce conflicts of interest between managers and owners.