Question

The principal-agent problem is a common source of inefficiency in many industries, sometimes seriously hurting society at large. Using your recently acquired understanding of this concept, identify a principal-agent problem and estimate the degree of economic inefficiency this problem creates. Propose economic solutions to this problem.

Answer 1

The principal-agent problem occurs when a principal delegates an action to another individual (agent), but the principal does not have full information about how the agent will behave. Secondly, the interests of the principal diverge from that of the agent, meaning that the outcome is less desirable than the principal expects.

Examples

Shareholder and Manager.Shareholder is the principal and manager is agent. Shareholder may want that profits should be maximized.But manager may not be that serious in earning profit and may work in a relaxed manner

CEO and Shareholders. CEO may be more interested in reinvesting the profits for growth of business but shareholder will be more interested in getting dividends.

Tenant and Landlord A landlord may be more interested in judicious use of his property like maintaining cleanliness and reducing electricity bills. But tenant may not care about all these things.

Economic Inefficiencies created by Principal Agent Problem

Moral Hazard.The principal-agent problem can also lead to an individual taking an excessive risk because the ultimate cost is borne by someone else. This is an example of moral hazard. Investment banker will aim at earning high profits . If he gets losses the same will have to be suffered by bank or taxpayer an not by individual banker.

Agency Costs. Because of Information Asymmetry principal may not be aware how much contract has been entered or he may be reluctant to enter into a contract.A tenant may not be intrested in renting property because of fear of damage. If this mutually beneficial transaction do not occur then this will result in welfare loss.

Producing sub optimal work. Another ineffeciency is created when the output is sub-standard. Managers are more concerned with their salary and may not be concerned with reducing costs or judicious utilization of the resources of organization.

Solutions to sove it

Performance Management. Paying incentives to workers for performing well and giving good quality work help to reduce this problem. But some workers are motivated more by pride, praise, love and respect as compared to pay.

Contract Clauses This helps in solving corporate problems to a large extent.The shareholders can take action before and after hiring a manager to overcome some risk. First, they can write the manager's contract in a way that aligns the incentives of the manager with the incentives of the shareholders. The principals can require the agent to regularly report results to them. They can hire outside monitors or auditors to track information. In the worst case, they can replace the manager.