Question

How would you characterize a firm that ignores the princple? Can you think of situations in which it would be advisable for an otherwise prudent firm to deviate from the principle?

Answer 1

The principle agent problem arises when one party (agent) agrees to work in favor of another party (principle) in return for some incentives. Such an agreement may incur huge costs for the agent, thereby leading to the problems of moral hazard and conflict of interest. Owing to the costs incurred, the agent might begin to pursue his own agenda and ignore the best interest of the principle, thereby causing the principal agent problem to occur. The costs to agent and subsequent conflict of interest arise due to the skewed information symmetry and the risk of failure faced by the principal.

For example: Shareholders of a company appoint managers to look after the proceedings of the company and earn profits on their behalf. The shareholders expect the managers to distribute all the profits to the shareholders. But the managers sensing their own growth and salary expectation try to retain the profits for future as a safe side. This can lead to principle agent problem. It is one of the most noticed problems in the current situation when most companies are not being managed by the owners themselves.

Thus the firm which ignore its principle is mean, self-centered and likely to fall down since it does not acknowledge its stakeholders and instead the management of the firm seeks their own self interests.

Deviation from principle may take place but the end result should be in the best interest of all the stakeholders.