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Analysis of Principal Agent Problem

I went to my college today and we talked about a very interesting topic in one of my finances lectures. We talked about principal-agent problem. In this article I will try to make a short analysis of principal agent problem. Many of you probably haven’t heard of it yet but I believe it’s very important for every manager to understand what principal agent problem is all about.[ad#ad-4]

First let’s remember how those big corporations work. We have shareholders who own stocks of that company, shareholders then select who will be in the control council and the control council then select the managers who will lead the company. As you can see the owning and the leading function is separated in big companies. On the other hand if we take a look at a small company for example, the owner and the worker is the same person so the goals are not an issue. While if we go back to the big companies, interests of manager or the leader of the company and owners of the company are not the same. For example stockholders want their stocks to be as high as possible and bring them as much of dividends as possible. While managers want the big paychecks, fancy cars, big offices and other luxuries that the company can offer to them.

It is very obvious that leading of the company varies depending on the goal we’re aiming at. If we’re following the goal of stockholders the manager of course cannot afford to buy a brand-new Mercedes or bigger office. And if we follow the goal of a manager a.k.a. leader, we cannot achieve goals of stockholders. Why not? Because manager will pay himself a big paycheck and buy himself luxuries and of course that will make the profit of the company smaller and consequently the value of stocks and dividends smaller as well.

This is a so-called principal agent problem. Principals are shareholders and they hire agents to work for them. Agents are in this case managers who have different goals as the owners of the company. Here starts the conflict or problem, Prinipal-Agent problem.

Written by: Matt

We also suggest this relevant article if you have time: 4 basic functions of management

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