Question

3. What is meant by the principal agent problem? In the case of the relationship between shareholders and management, who is the principal and who is the agent? What is an example of something that the agent in this case might do that would be in conflict with the goals of the principal? What actions could the principal take to try to prevent (or at least reduce) this problem?

Answer 1

What is meant by the principal agent problem?

Agent is a person who acts on behalf of another person to represent such another person in front of customers or others, as the case may be. Person who acts behalf of another person is called as Agent and the another person for whom Agent works is called as Principal. Under the Principal-Agent relationship, Agents are required to carry out only those activities which are authorized and approved by the Principal. In other words, Agent cannot act on his own judgements without Principal's consent towards the same.

In the case of the relationship between shareholders and management, who is the principal and who is the agent?

In the case of the relationship between shareholders and management, management is the principal and is the agent because management is formed and is expected to act towards organization growth and shareholders wealth on behalf of shareholders. So, shareholders are the Principal and management is the Agent.

What is an example of something that the agent in this case might do that would be in conflict with the goals of the principal?

In terms of distribution of profits by the management to the shareholders in terms of dividends, it is not necessary that the management shall declare and pay dividends to shareholders whenever company earns profits. That is, management shall decide whether to declare dividends or to retain the earnings in the business itself for any future plans. However, shareholders, as investors, will be interested in receiving more dividends not concerned about company's profits and future plans. Here, the Principal-Agent problem arises.

What actions could the principal take to try to prevent (or at least reduce) this problem?

Principal (the shareholders) can elect one or two shareholder(s) among them to hold office in board of directors to prevent or at least reduce this problem because those who are holding office as directors will know what the management plans for and how shareholders' expectaton towards dividends can be handled. They can analyze and conclude about company's dividend decisions in such a way that the same is guaranteeing investors a decent return on their investment in terms of share capital and saving management to encounter any disputes with the shareholders.