- Principal-agent problem
- The principal-agent problem arises when an agent hired to act for a principal pursues aims of its own, which the principal cannot fully see or control.
- Corporate governance
- Corporate governance is the name economists give to the institutions that are supposed to watch over top executives on behalf of the owners.
Why the agent can drift from the principal's aims
Can you name the two conditions that create a principal-agent problem, and the three checks that limit it?
The problem needs both conditions: different aims, and information the owners do not have.
Different objectives means the agent wants something other than what the principal wants, such as managers seeking pay, status or an easy life rather than the owners' profit.
Can you think of an example?
A chief executive buys a rival firm that makes the company, and her salary, much bigger, though shareholders' profit per share falls.
Asymmetric information is where one party has more information about a transaction than the other, as managers know far more about the firm than its owners.
Can you think of an example?
A manager knows a new product is behind schedule and over budget. The shareholders, reading an upbeat annual report, do not.
The board of directors, elected by the shareholders, is supposed to be the first line of oversight, making sure the firm runs in the owners' interests.
Can you think of an example?
A board votes to replace a chief executive after two years of falling profits, against the executive's wishes.
Auditors are the outside firm hired to review the company's financial records and certify that everything looks reasonable, so owners can trust the figures.
Can you think of an example?
Auditors refuse to sign off a retailer's accounts until it restates profits that counted sales before they had been made.
Performance-related pay ties managers' rewards to what the owners want, for example by paying them partly in shares, so the agent gains when the principal does.
Can you think of an example?
A chief executive is paid largely in shares she cannot sell for five years, so she gains only if the firm's value rises over that time.