Th3.1: The Principal Agent Problem Flashcards
What is there in many large firms?
separation of ownership and control
Firms are owned by…
their shareholders who play no part in the day to day running of the business
Who work for the company and control day-to-day decision making?
the chief executive and senior managers
Who are shareholders represented by?
a Board of Directors who oversee the way the business is run - they are able to vote directors onto and off the board
Despite the voting, this often makes little difference, so shareholders have more power through…
buying and selling shares - if share prices drop significantly the board may be encouraged to change their strategy
This separation causes problems due to…
the differing aims of the two stakeholders
The owners will want to maximise the returns on their investments so will want to…
short run profit maximise
However, directors and managers are unlikely to want the same thing - as employees they will want to…
maximise their own benefits
What is the principal agent problem?
where the agent makes decisions on behalf of the principal - the agent should maximise the benefits of the principal but have the temptation of maximising their own benefits
It is for this reason that many firms are not run to profit-maximise but to…
profit satisfice
How could the issue be overcome?
by giving managers shares in the businesses or linking their bonuses to profits - this will mean that they personally will gain from higher profits
