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How to Solve Principal-Agent Problem

If you want to understand this article, you will first need to know what principal-agent problem actually is. You can read more about it on the link above. I will try to explain three reasons/ways to solve this problem.[ad#ad-4]

First let’s split it on two reasons, reward and punishment. Punishment is direct fire and take over of a company. The rewards can bi in many different forms. I will explain each of those three principal-agent problem solutions in more details below.

Getting fired: Well I don’t think there is much more that needs to be said here. If the manager does not work very well, there is a threat that shareholders will replace him. Out of that reason, he trys to work as hard as he can… (in theory)

Take over: If the management is doing a bad job, then company is doing a bad job. Now if the company is doing a bad job, then company is not achieving it’s maximum value on the market. That is a sign for big investors to take over the company, change the management and by doing that, they will increase the market value of stocks which will, of course, bring them grat profit, since they own the company. Out of that reason, the management is working by the principals/company best interests.

Reward: There are many ways that principals can reward their managers. Most often used one is in form of stocks or stocks options. Why is that better than just cash? Well by giving managers some stocks, you make them direct part of the ownership and their interest is to increase the market value of stocks. So you do not actually remove the principal-agent problem, you make agent a principal and avoid different interests by you and him.

Ok, this was shortly about principal-agent problem. Hope you managed to learn something new out of it and hope you will lead your managers better becouse of this article.

Written by: Matt

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

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