Week 11 - The Principal-Agent Problem Flashcards
What is a key feature in modern business?
Separation of ownership and control.
A firm’s central office may set strategy, but its employees must implement it. Accordingly, the firm has to address some questions.
What three questions must a firm address?
(a) How should the firm measure the performance of its employees?
(b) How should it use those performance measures to reward employees for actions that advance
the firm’s strategy?
(c) Are there risks associated with tying rewards to specific performance measures?
When does a principal/agent relationship occur?
A principal/agent relationship occurs when one party (the agent) is hired by another (the principal) to take actions or make decisions that affect the payoff to the principal.
What does the principal/agent problem concern?
The principal/agent problem concerns the difficulties in motivating the agent to act in the best
interests of the principal rather than in his or her own interests.
What are some principal/agent examples?
(a) The CEO (agent) and Shareholders (principal)
- CEO has to act in best interest shareholders, but the best interest of management might not be in best interest for shareholders.
(b) Firm’s Owners and Employees (managers, workers,…).
(c) Litigant and Lawyer
- A lawyer being paid by the hour has an incentive to do things slowly when the client’s interest might be best served by doing it rather more quickly
(d) Insurer (the principal) and the insured (the agent)
(e) Politicians (agent) and voters (principal)
What are the reasons for the principal/agent problem arising?
(a) Inconsistent Objectives: The objectives of the principal and the agent are different.
(b) Hidden Action: The actions of the agent are not observable by the principal.
(c) Hidden Information: The information possessed by the agent is not observable by the
Principal.
Explain the following reason for the principal/agent problem: inconsistent objectives
- Owners/managers
o Firm owners and managers normally have different objectives, which could potentially create serious problems (think about Enron scandal and GFC.)
o Objectives of Firm Owners:
To maximum profits while taking on a reasonable degree of risk
o Objectives of Managers:
Enhancing their personal wealth;
Limiting their personal risk;
Boosting their prospects for the next job - Litigant/lawyer
o Objectives of a lawyer:
Help the litigant but may also prefer to spend time on more prominent or remunerative cases
Simply engage in leisure activities
o Objectives of a litigant:
To achieve a favourable outcome in court
Explain the following reason for the principal/agent problem: hidden action and hidden information
Example: Garment factory fire insurance
- Max Blanck and Issac Harris operated several garment factories (including Triangle Waist Company and Diamond Waist Company) in New York around 1900s.
- Fashion business then was risky – had to make production decisions well in advance, and demand forecasting errors combined with consumers’ fickle tastes meant that unsold inventory could stack up, especially in the spring and fall when the fashion seasons drew to a close.
- Several fires struck Blanck and Harris operations:
o Triangle Waist Company: April 5 1902, Nov 1 1902, March 25 1911
o Diamond Waist Company: April 1907, April 1910
- Each fire occurred as the firm ended a fashion season, right when concern over unsold inventory was greatest.
- The stacks of inventory were destroyed, and the insurers dutifully paid up the loss.
We have a severe principal/agent problem here. A fire insurance contract, once is signed, the
precautionary actions taken by the insured (the agent) affect the payoff to the insurer (the principal).
- The insured could be careful removing any flammable materials from the property and keeping fire alarms and hoses operational, or could toss a lit match into a pile of fabric scraps in early April morning.
- It creates moral hazard problems due to hidden actions.
What are three tools for resolving the principal/agent problem?
- Monitoring
- Pay-for-performance incentives
- Bureaucracy
Explain the following tool for resolving the principal/agent problem: monitoring
Expending resources on monitoring the management/employees can mitigate the principal/agent
Problem, but:
- Monitoring can be expensive
- Monitoring can be imperfect
- Monitoring can add an extra layer in the principal/agent relationship
Explain the following tool for resolving the principal/agent problem: pay-for-performance incentives
Principal offers to link the agent’s pay to the payoff the principal receives from the agent’s actions. Some examples:
- Sales commissions (department stores like Nordstrom and Bergdorf Goodman; real estate agents). However, monetary incentives only partially resolve the principal-agent problem.
- Stock options for executives; Procter & Gamble offers year-end bonuses to brand managers that are linked to the profit generated by their brands.
- Non-monetary rewards (Century 21 offers an annual top agent retreat)
Performance-based Incentives: The Case of Franchising
- Franchising allows one firm (the franchisee) to use the trade name and business plan of another (E.g. McDonald’s; Burger King; KFC; Nando’s).
- The franchisee makes a one-time payment of a franchise fee, then the franchisee pays the franchisor a royalty, a fixed fraction of the franchisee’s sales.
- In average, the franchise fee is $23300, and the royalty rate is 6.4 percent.
- The typical franchisee keeps 94 cents of every additional dollar of revenue generated and 100 percent of any dollar in cost savings.
Explain the following tool for resolving the principal/agent problem: bureaucracy
Bureaucracy refers to excessively complicated administrative procedure. Bureaucracy limits the set of actions an employee can take
- An example is limits on discounting by the sales force
- Discounting by one sales person may increase his/her compensation while lowering the overall profits for the firm.
How do firms provide incentives when explicit, pay-for-individual-performance contracts are not feasible?
Firms may provide incentives using implicit contracts that involve subjective performance evaluation.
How do firms implement subjective performance evaluation?
- 360-degree peer reviews: An employee’s supervisor, co-workers, and subordinates are all asked to provide information regarding that employee’s performance over a period of time.
- Management-by-objective systems: An employee and a supervisor work together to construct a set of goals for the employee, at the end of some specified period, the supervisor and the employee meet to review the employee’s performance on the present goals.
- Merit rating systems: Employees are given numerical scores.
What is one important way in which subjective evaluations are used in determining payoffs to employees?
Through promotions and firing.
