Principal–agent problem (agency dilemma)
The principal–agent problem, also known as the agency dilemma, occurs when there is a conflict of interest between two parties in a relationship: the principal, who delegates authority, and the agent, who acts on behalf of the principal. This scenario is common in various settings, including businesses, where shareholders (principals) may have different incentives than company managers (agents). For instance, agents might prioritize personal gains over the interests of the principals, leading to decisions that could be detrimental to the organization, such as financial mismanagement or nepotism in hiring practices.
The problem is not limited to corporate structures; it can also arise in personal situations, such as when a homeowner hires a real estate agent who may not align with the homeowner's objective of maximizing sale price. One notable case illustrating this dilemma is the Enron scandal, where executives manipulated financial information for personal benefit, ultimately causing significant losses to shareholders and employees. Solutions to mitigate the principal-agent problem often involve aligning interests through compensation structures, such as stock options or performance-based bonuses, and long-term contracts that encourage agents to consider the long-term health of the organization. Understanding this dilemma is crucial for effective management and decision-making across various sectors.
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Principal–agent problem (agency dilemma)
The principal–agent problem, which is also called the agency dilemma or agent problem, is a problem that happens at various institutions, such as businesses. The idea is that agents who work on behalf of principals might not have the same motivations as principals. For example, the agent might be an employee working for an employer, the principal. The principal relies on the agent, but the agent might have different motivations than the principal and might make decisions that are unhelpful and even harmful to the principal. The principal–agent problem is an important concept in economics and other social science disciplines.
Background
The principal–agent problem deals with two parties in an organization: the principal and the agent. In economics, the term principal has several meanings. One meaning is the owner of a business or the person or party that initiates a transaction. A principal can also be a board member or a shareholder in a particular business. A business can have more than one principal. For example, businesses can have many shareholders, and all the shareholders can be considered principals. Principals also exist outside businesses. A person who is selling a home and who hires someone else to sell that home is the principal in the transaction. Similarly, a person who hires a lawyer is a principal. In economics, an agent is someone who is working for a principal to complete a particular job. For example, managers who are running a company for the shareholders (principals) are the agents. Likewise, a real estate agent and a lawyer are both agents for the people who hire them (principals). When principals use agents, they incur something called agency cost. An agency cost is any cost that arises from hiring an agent. Agency costs can include benefits, such as performance bonuses and stock options, for agents.
Overview
The principal–agent problem is a commonly discussed in economics, but it can happen in a number of situations. One of the most common examples of the principal–agent problem is a business in which the principals (e.g., shareholders) have different motivations than the agents in the company. Agents, such as managers, can have different motivations than the shareholders or other principals. For example, mangers may be interested in gaining money for themselves and less interested in earning money for the company. In that situation, managers could make decisions that benefit themselves and do not benefit the overall business. For example, managers could steal money from the company. This would be beneficial for the agent, but it would be harmful to the principals. Another possible problem could be that an agent would hire a family member or a friend. This might benefit the agent, but if the person being hired is not the best candidate for the job, it would not be beneficial for the company overall. Another way that agents could make decisions that benefit themselves without benefiting the overall company is by misusing company resources. For example, if the managers in a company spend company resources on luxury travel accommodations, then they are acting in their own self-interest and not in the interest of the principals.
Another example of the principal–agent problem is a person selling a home. That person could hire a real estate agent. A principal might choose to hire an agent because the agent understands the real estate market and because the agent has more time to devote to selling the home. Although this relationship should be beneficial for both parties, the principal–agent problem could make it less beneficial for the principal. For example, the agent could want to sell the home for less money than the principal is interested in selling it for. Another example of the principal–agent problem outside of business is that of a lawyer working for an hourly wage. The lawyer, or agent, might take longer working on a case then necessary to make more money, which will cost the client (the principal) more.
A real-life example of the principal–agent problem is the Enron scandal that occurred in the United States in 2001. Enron was an energy-trading and utilities company that committed accounting fraud. It was a publicly traded company, and its principals were shareholders. The agents at Enron were the executives making the financial decisions. To make the company look more financially successful than it was, some of the agents made up financial information for the company. This falsification of the financial information eventually led to the company going bankrupt. Hundreds of employees lost their jobs and all the shareholders, the principals, lost the value of their stocks. The agents were acting in their own self-interest by trying to make themselves look successful, and they were not acting in the interest of the principals.
Economists have identified a number of possible solutions to the principal–agent problem. One of the most common solutions companies use is to include stock options in the agent’s compensation package. This incentive can become problematic when agents become willing to sacrifice almost anything to increase share prices. Some companies also create targets for agents to reach, and agents receive bonuses when they meet the targets. Another possible solution is to incentivize agents by forcing them to enter long-term employment agreements. In theory, these agreements should help solve the principal–agent problem because the agents will have the goal of increasing the company’s overall profit in the long term. Apple, the technology company, hoped to solve the principal-agency problem when it required its workers (agents) to own shares of Apple stock and enter work contracts. By making the Apple employees own shares of the company, the company helped ensure that the agents would think both as agents and as principles.
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