Question

What are agency problems and how do they come about? Please provide an example of an agency problem and show how it can be mitigated.

Answer 1

Ans ) Agency problem : is a conflict of interest inherent in any relationship where one party is expected to act in another best interest in corporation finances the agency problem usually refers to a conflict of interest between a company management and the company stock holder .

For example ,

a principal will hire a plumber ( the agent ) to fix plumbing issues although the plumber's best interest is to collect as much income as possible ,he is give the responsibility to perform in whatever situation results in the most benefit to the principal .

Agency problem arises due to an issue with incentives and the presence of discretion in task completions.an agent may be motivated to act in a manner that is not favourable for principal if agent is presented with an incentive to act in this way in case of plumbing example the plumber make 3 times as much money by recommended a service the agent does not need.an incentives ( three times the pay ) is present , causing the agency problem to arises.

Way to overcome agency problem

1. Full transperency : when agency problem arises then practice full transperency can help close knowledge gap and prevent the agency problem from emerging
2. Restrictions on agent capabilities : giving too much power to act on your behalf open the doors for future challenge and can lead the financial adviser to perhaps make poor choices. Most successful government practice check and balance because it tempers the power of any one individual.
3. Commission and bonus structustructur : simplest method of eliminating the agency problem is to remove financial incentives that encourages conflicts of interest .if advisor received set salary or earns commission based on total assets under management rather than specific product sale,the agency problem disappeared.

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