Principal-Agent Problem: Conflict & Asymmetry - Essay Sample

Introduction

The theory of principal-agent problem occurs when a person can make an important decision and take action on behalf of another person. For instance, when a manager decides a business organization on behalf of the shareholders. In a principal-agent relationship, the principal party assigns the agent to decide on its behalf. Typically, a principal-agent problem occurs as a result of possible conflicts of interest between two parties and the asymmetric problem that exists between them. The agent, in this case, is prompted to act based on his/her interest disregarding the principal's interest (Vaida, 2011). In a perfectly competitive market, the pressure solves the problem of incentives for cost minimization. Ideally, the theory of principal-agent problem does not explain how the owners of the business organizations manage to put in order the objectives of their various managers and supervisors to maximize profit.

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(Foss and Stea, 2014) maintains that, when looking at a firm in a broader angle, both the managerial and agricultural economics, the business inducement becomes central. The owners of the organization must delegate some of the firm tasks to the managers and supervisors. The theory of the principal-agent problem realized the decentralized nature of the information but proposed identical objective functions for the members of the firm contemplated as a team. The theory concentrates on how to coordinate the deeds of the members of the organization through proper management of information. Fundamentally, the transference of a task to an agent who has unique goals than the principal becomes problematic when the information provided by the agent is misleading (Frentrop, 2012). Conflicting objectives and decentralized information are the primary constituents of this theory.

Additionally, if the agent happens to have a different objective with no private information, the principal can come up with an agreement that perfectly controls the agent and also persuades the latter deeds to be what he would like without delegation. Private information can be of two types, a case where the agent takes action without the principals' knowledge and a situation where the agent happens to have private information about its cost that the principal has ignored. According to (Bebchuk and Fried, 2003), the owners of the business use the mechanism design theory in order to understand the allocation of resources by the agent when the information is decentralized. In other words, the principals benefit from auctions when competing with their agents.

Principal Agency Problem

Consequently, the board of governors may fail to function effectively in controlling the corporation when the principal agency problem continues to not being addressed. As a result, the board of governors will therefore delegate certain decisions to the agent to act in the shareholder’s self-interest (Levin, 2014). The agency problem occurs as a result of the shareholders having a conflict with the agent. In most cases, the principal expects that their agent will perform specific duties with the principal best of interest in mind. The situation becomes more complicated when it is a case of corporate organization, where the shareholders are comprised of many groups and individuals who have different opinions concerning the organization's decision. The agency problem becomes costly when the shareholders lose the effective control of the organization, thereby leaving the important corporate decisions to the manager.

According to (Ulhøi, 2006), lack of understanding from the managers and the shareholders can cause feasibility in that, the shareholders must apportion some of the decision making rights to the director. As a result, the directors can determine their benefits of surveying, which are unreachable to shareholders. The inefficiency of the shareholders will increase managerial bonuses to maximize the decision value. Additionally, the failure of the board of governors to function effectively is mostly caused by self-interested behavior from the managers. The rising conflict causes severe implications for corporate governance and business ethics (Jankensggrd, 2015). Because of the asymmetric information, the agents can conduct decisions based on their self-interest.

In a condition where information is asymmetrical between the shareholders and the managers, an agency problem may arise as a result of having issues with incentives and a task completion problem (Tietjens Meyers, 2016). The principal theory relates to the example since there is lack of effective control by the shareholders thus the manager is prompted to acts based on his or her interest. In order for the shareholders to control the principal agency problem, they tend to concentrate on the manager's self- interest by offering a large package of compensation. Furthermore, the shareholders use incentives programs to incentivize an agent to act in compliance with the shareholders' self-interest by giving rewards to the managers based on performance and compensation. For instance, principals who happen to be the shareholders of the institution can give the director an incentive that relates the compensation directly to the stock price performance. As a result, the chief executive officer might try to prevent a takeover; hence it may cause an agency problem. From the example, it can be concluded that the organization had asymmetrical information since the shareholders could not control the corporate decisions; hence they had to offer a significant compensation package to the chief executive officer to represent their interests.

The substantial compensation given to the manager by the board of governor was a way of minimizing the risk associated with agency problems. Giving the chief executive officer the compensation, was meant to avoid agency costs which occur as a result of having an agency problem. Agency cost includes all the costs of inefficiencies that might occur when an agent is doing a specific task. The principal-agent problem arises when the is a conflict between two parties that happen to have a different interest and misguided information (Bednarczyk and Eichler, 2002). From the example, the board of governors may have different ideas and opinions regarding the organization's objectives. These creates an agency problem that makes the board to delegate their decision to the CEO who is well supplied with the information needed to run the organization. Fundamentally, a principal agency problem may arise when the chief executive officer refuses to share the profits to all the shareholders and instead of retaining the gain in order to secure their growth. The shareholders will try to solve the issue by compensating the CEO to ensure they get the share of the profit.

Problems of Implementing Principal Agency Theory

Implementing the principal theory in practice can be problematic since the agent sometimes does not consider the shareholder's interest. It happens because of the asymmetric information where the agent has more information than the shareholders of the organization (Brehm and Gates, 2014). As a result, the owner of the organization does not know how the agent will act. Moreover, it becomes hard for the organization to ensure that the agent will work on the principals' best interest, thus having agency costs. In most cases, the agent does not prioritize the best interest of the principal; hence the agent ends up working on his objectives. The principal-agent problem is associated with market failure since most resources are not allocated where there are needed, thus creating inefficiency in the market place (Choi, 2015). Market failure occurs as a result of power abuse from either the manager or the shareholders of an institution.

Implementing the principal agency problem will result in the principals minimizing the agent's cost by imposing internal controls to prohibit the agents self- serving conduct. (Byun and Kim, 2013) reasons that if there is no contradiction of objectives between the principal and the agent, then the agent's self-regarding behavior will result in maximization of wealth by the principal. On the other hand, the idea of better objective alignment between the principal and the agent through remuneration incentives and the partial ownership will result in prompting the agent to maximize his or her utility and also at the same time maximizing the wealth of the firm (Busch, 2016). Even though the agency theory can be used to explain the relationship between the agents and the principals, implementing the theory will limit the explanatory power once the principal decides to invest in new business risk. These is because the objectives of the principal and the agent will likely put in order, thereby palliating a potential agency problem. In addition, after the principal has decided to change into new business risk, he or she is expected to change from being a cautious capitalist to being a more willing collaborator.

Nonetheless, even after the principals become shareholders in a venture, the agents will likely still maintain the critical interest hence they will remain to be the significant principals despite the fact that the percentage of possession is likely to reduce as long as the principal is funding the objectives of the organization (Schneider and Mathios, 2006). Technically, if the agents were to involve themselves in conducts that will harm both the principal and the organization, they will, in turn, damage their long term financial magnitude by escalating the likelihood of the new business to fail, which will hurt the agent more than the invested principal. The arguments relating to the agency theory pirouette around the theory's main concern with the governance procedures to secure the investments from shirking conduct. On the upside, the agency theory is limited because an agent is supposed to have a little consternation about the long-term success and direction of the success of the new business venture. On the downside, since the agent will be concerned with his or her depositary to those providing finance, it becomes unlikely that the agent will completely abandon his or her vision for the venture with the principal (Padilla, 2004).

Incentives

Providing incentives to the chief executive officer in order to improve performance only creates room for more problems to exist since it decreases production. Incentives extinguish motivation that keeps the employees more focused on available tasks despite the challenges. According to (Kräkel and Müller, 2015), incentives make people lose focus, thereby diminishing the performance. Research shows that the higher the reward, the worst the performance exhibited by the employee. Customarily, incentives create a focus on premium instead of the objective of the organization. Additionally, incentives make people crush their creativity by narrowing their focus (Moore, 2014). For instance, most organization requires a creative employee with a high level of creativity will make them less effective when needed. In addition, incentives can crowd out good behavior, thus affecting their ability to make significant decisions. They can also encourage cheating and unethical behavior when they are tied to sales quotas and revenues.

Incentives problem can be overcome by revisiting the firm's incentives program to ensure that the program is appropriately delineated with the right intentions. Incentives that bring out unethical behavior should be solved by concentrating more on the actions that will lead to the expected outcomes. Furthermore, organization leaders should make sure they accentuate accountability for moral actions (Schmitz, 2017). Incentives that diminish the perfor...