principal-agent theory

principal-agent theory

the relationship between the owner (principal) of an asset (for example, a company) and the persons (agents) CONTRACTED to manage that asset on the owner's behalf (for example, the appointed executive directors of the company).

Where contracts are complete, there is little scope for deviations from the objectives and requirements of the principal and the expected obligations and duties of an agent. However, most contracts are incomplete to a greater or lesser degree so that problems can arise (so-called ‘agency costs’). For example, agents may pursue a ‘hidden agenda’, substituting their own objectives for those of the principal (see below), or ASYMMETRICAL INFORMATION favouring agents who (as ‘insiders’) are involved in day-to-day management may make it difficult for principals (as ‘outsiders’) to monitor the behaviour of executive directors. Further down the organization, problems of MORAL HAZARD may arise as employees indulgein ‘shirking’, working at less than optimal efficiency.

The principal-agent relationship is at the heart of the analysis of ownership and control issues in the modern JOINT-STOCK COMPANY, where it has been observed that although the SHAREHOLDERS of the company are its owners, effective control of the company is in the hands of the board of directors. Shareholders are usually too fragmented and too remote from the ‘seat of power’ to exercise strong control and are generally prepared to leave it to the executive directors to determine the affairs of the company. This can lead to conflicts of interests whereby directors may pursue courses of action which may be detrimental to shareholders (e.g. use current profits to diversify into risky new business ventures rather than pay higher dividends). See BUSINESS OBJECTIVES.

To get round these problems, principals may utilize various incentive payment schemes to align agents' interests more closely with their own and encourage dedicated attention to optimum performance. These include: EXECUTIVE SHARE OPTION SCHEMES, LONG-TERM INCENTIVE PLANS, EMPLOYEE SHARE OWNERSHIP PLANS and payment by PIECEWORK and COMMISSION.

principal-agent theory

the relationship between the owner (principal) of an asset (for example, a company) and the persons (AGENTS) contracted to manage that asset on the owner's behalf (for example, the appointed executive directors of the company).

Where contracts are complete, there is little scope for deviations from the objectives and requirements of the principal and the expected obligations and duties of the agent. However, most contracts are incomplete to a greater or lesser degree so that problems can arise (see AGENCY COSTS). For example, agents may pursue a ‘hidden agenda’, substituting their own objectives for those of the principal, ASYMMETRICAL INFORMATION favouring agents who (as ‘insiders’) are involved in day-to-day management, making it difficult for principals (as ‘outsiders’) to monitor the behaviour of executive directors. Further down the organization, problems of MORAL HAZARD may arise as employees indulge in ‘shirking’, working at less than optimal efficiency (see TEAM PRODUCTION).

To get round these problems, principals may utilize various incentive payment schemes to align agents’ interests more closely with their own and to encourage dedicated attention to optimum performance. These include: EXECUTIVE SHARE OPTION SCHEMES, LONG-TERM INCENTIVE PLANS, EMPLOYEE SHARE OWNERSHIP PLANS and payment by PIECEWORK and COMMISSION.

The principal-agent relationship is at the heart of the analysis of ownership and control issues in the modern JOINT-STOCK COMPANY, where it has been observed that although the SHAREHOLDERS of the company are its owners, effective control of the company is in the hands of the board of directors. Shareholders are usually too fragmented and too remote from the ‘seat of power’ to exercise strong control and are generally prepared to leave it to the executive directors to determine the affairs of the company (see DIVORCE OF OWNERSHIP FROM CONTROL). This situation has led economists to hypothesize that whereas shareholders are typically interested in profit growth (EARNINGS PER SHARE), the size of dividend payouts and TOTAL SHAREHOLDER RETURN (increase in share prices/dividends), executives, as salaried managers, are more interested in increasing the size of their own remuneration, perks and ‘lifestyle’. Thus, the THEORY OF THE FIRM has been reformulated to embrace, in addition to the conventional assumption that firms seek PROFIT MAXIMIZATION as their objective, more managerial imperatives, particularly an emphasis on the size of the firm because ‘bigger firms pay bigger salaries’. See MANAGERIAL THEORIES OF THE FIRM, SALES-REVENUE MAXIMIZATION, ASSET-GROWTH MAXIMIZATION, MANAGEMENT-UTILITY MAXIMIZATION, BEHAVIOURAL THEORY OF THE FIRM, SATISFICING THEORY, FIRM OBJECTIVES, CORPORATE GOVERNANCE.

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