The Principal–Agent Problem

If monitoring the productivity of workers were costless, the owners of a busi­ness would ensure that their managers and workers were working effectively. In most firms, however, owners can’t monitor everything that employees do—employees are better informed than owners. This information asymmetry creates a principal-agent problem.

An agency relationship exists whenever there is an arrangement in which one person’s welfare depends on what another person does. The agent is the person who acts, and the principal is the party whom the action affects. A principal- agent problem arises when agents pursue their own goals rather than the goals of the principal. In our example, the manager and the workers are the agents, and the owners of the firm are the principals. In this case, the principal-agent problem results from the fact that managers may pursue their own goals, even at the cost of lower profits for the owners.

Agency relationships are widespread in our society. For example, doctors serve as agents for hospitals and, as such, may select patients and do procedures which, though consistent with their personal preferences, are not necessarily consistent with the objectives of the hospital. Similarly, managers of housing properties may not maintain the property the way that the owners would like. And sometimes insured parties may be seen as agents and insurance companies as principals.

How does incomplete information and costly monitoring affect the way agents act? And what mechanisms can give managers the incentives to oper­ate in the owner’s interest? These questions are central to any principal-agent analysis. In this section, we study the principal-agent problem from several perspectives. First, we look at the owner-manager problem within private and public enterprises. Second, we discuss ways in which owners can use contrac­tual relationships with their employees to deal with principal-agent problems.

The Principal-Agent Problem in Private Enterprises

Most large companies are controlled by management. Individual stockholders, who are not part of management, typically own only a small percentage of the equity of these companies, and thus they have little or no power to fire managers who are performing poorly. Indeed, it is difficult or impossible for stockhold­ers to even learn much about what the managers are doing and how well they are performing. Monitoring managers is costly, and information can be expen­sive to gather. The result is that managers can often pursue their own objectives, rather than focusing on the objective of the stockholders, which is to maximize the value of the firm.

But, what are objectives of managers? One view is that managers are more concerned with growth than with profit per se: More rapid growth and larger market share provide more cash flow, which in turn allows managers to enjoy more perks. Another view emphasizes the utility that managers get from their jobs, not only from profit but also from the respect of their peers, the power to control the corporation, the fringe benefits and other perks, and long job tenure.

However, there are limitations to managers’ ability to deviate from the objectives of owners. First, stockholders can complain loudly when they feel that managers are behaving improperly. In exceptional cases, they can oust the current management (perhaps with the help of the board of directors, whose job it is to monitor managerial behavior). Second, a vigorous market for corpo­rate control can develop. If a takeover bid becomes more likely when the firm is poorly managed, managers will have a strong incentive to pursue the goal of profit maximization. Third, there can be a highly developed market for manag­ers. If managers who maximize profit are in great demand, they will earn high wages and so give other managers an incentive to pursue the same goal.

Unfortunately, the means by which stockholders control managers’ behavior are limited and imperfect. Corporate takeovers may be motivated by personal and economic power, for example, instead of economic efficiency. The manage­rial labor market may also work imperfectly because top managers are frequently near retirement and have long-term contracts. The problem of limited stockholder control shows up most dramatically in executive compensation, which has grown very rapidly over the past several decades. In 2002, a Business Week survey of the 365 largest U.S. companies showed that the average CEO earned $13.1 million in 2000, and executive pay has continued to increase at a double-digit rate. Even more disturbing is the fact that for the 10 public companies led by the highest-paid CEOs, there was a negative correlation between CEO pay and company performance.

It is clear that shareholders have been unable to adequately control managers’ behavior. What can be done to address this problem? In theory, the answer is simple: One must find mechanisms that more closely align the interests of man­agers and shareholders. In practice, however, this is likely to prove difficult. Among those suggestions put into effect recently by the Securities and Exchange Commission, which regulates public companies, are reforms that grant more authority to independent outside directors. Other possible reforms would tie executive pay more closely to the long-term performance of the company.

Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.