Question

How does the increasing dependence of firms on sources of external finance lead to the ‘Principal Agent’ problem? Does the ‘Principal Agent’ problem arise more widely throughout large organisations? Why is the ‘Principal Agent’ problem such a difficult problem to deal with?

Answer 1

The increasing dependence on sources of external finance leads to the problem of Principal Agent. This is because external sources of finance increase the number of shareholder of the firm referred to as Principal in the Principal Agent Problem. Now, the intrests of these shareholders mismatches with those of the Agents or the mangers of the business as both act in their own self interest and this leads to the problem of principal Agent. This increases as external sources of financing are used by the firm because this separates managers from shareholders and thus leads to the problem of Principal Agent.

Yes, this problem arises throughout large organizations because as the size of the organization increases, the numner of shareholders increases and also number of managers increases which also leads to the problem of principal Agent.

It is a difficult problem to deal with because the two parties involved have different interests and asymmetric information such that the principal cannot directly ensure that agent is always acting in the principal's best interest, particularly in case of activities that are useful for the principal are costly for the agent. Thus, the problem of moral hazard and asymmetric information makes the problem difficult to deal with.