Which of the following is the source of the principal–agent problem in publicly traded companies?

The conflict of interest between the agent and the principal

Inhaltsverzeichnis Show

• Reasons Behind Principal-Agent Problems
• Examples of Principal-Agent Problem
• Solutions to the Problem
• Related Readings
• Which of the following makes the principal
• What following might be an example of principal
• What factors create principal
• Which of the following is an example of the principal

A principal-agent problem arises when there is a conflict of interest between the agent and the principal, which typically occurs when the agent acts solely in his/her own interests. In a principal-agent relationship, the principal is the party that legally appoints the agent to make decisions and take actions on its behalf.

To learn more about similar topics, you can take CFI’s behavioral finance fundamentals course, which explores the fundamental issues of psychology on the behavior of financial agents.

The separation of the “ownership” (principal) and the “control” (agent) in principal-agent relationships creates the grounds for potential conflict of interests between the two parties.

Reasons Behind Principal-Agent Problems

The main reasons for the principal-agent problem are conflicts of interests between two parties and the asymmetric information between them (agents tend to possess more information than principals). The principal-agent problem generally results in agency costs that the principal should bear. Because agents can act in their interests at the principals’ expense, the principal-agent problem is an example of a moral hazard.

The principal-agent problem was conceptualized in 1976 by American economists, Michael Jensen and William Meckling.

The problem has applications in political science and in economics. It is especially significant in the understanding of corporate governance.

Examples of Principal-Agent Problem

The following cases are among the most common examples of the principal-agent problem:

• Shareholders (principal) vs. management (agent)
• Voters (principal) vs. politicians (agent)
• Financial institutions (principal) vs. rating agencies (agent)

Solutions to the Problem

Solutions to the principal-agent problem aim to align the interest of both parties. There are two main areas of improvement to address the problem:

1. Contract design

The main purpose of contract design is the creation of a contract framework between the principal and the agent to address issues of information asymmetry, stimulate the agent’s incentives to act in the best interests of the principal, and to determine procedures for monitoring agents.

2. Performance evaluation and compensation

The agent’s compensation is the primary method of aligning the interests of both parties. In order to address the principal-agent problem, the compensation must be linked to the performance of the agent.

The performance of the agent is usually measured by subjective evaluation because it is a more flexible and balanced assessment method for complex jobs. Common methods of agent compensation include stock options, profit-sharing, and deferred compensation. Tying the agent’s compensation closely to the benefits obtained for the principal helps to eliminate conflicts of interest.

Related Readings

Thank you for reading CFI’s guide on Principal-Agent Problem. To keep learning and advancing your career, the additional CFI resources below will be useful:

An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. In corporate finance, an agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize their own wealth.

• An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in the best interest of another.
• Agency problems arise when incentives or motivations present themselves to an agent to not act in the full best interest of a principal.
• Through regulations or by incentivizing an agent to act in accordance with the principal's best interests, agency problems can be reduced.

The agency problem does not exist without a relationship between a principal and an agent. In this situation, the agent performs a task on behalf of the principal. Agents are commonly engaged by principals due to different skill levels, different employment positions, or restrictions on time and access. 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, they are given the responsibility to perform in whatever situation results in the most benefit to the principal.

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

Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; board members and shareholders; and lawyers and clients. A fiduciary is an agent that acts in the principal's or client's best interest. These relationships can be stringent in a legal sense, as is the case in the relationship between lawyers and their clients due to the U.S. Supreme Court's assertion that an attorney must act in complete fairness, loyalty, and fidelity to their clients.

Agency costs are a type of internal cost that a principal may incur as a result of the agency problem. They include the costs of any inefficiencies that may arise from employing an agent to take on a task, along with the costs associated with managing the principal-agent relationship and resolving differing priorities. While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk of agency costs.

Principal-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. The Fiduciary Rule is an example of an attempt to regulate the arising agency problem in the relationship between financial advisors and their clients. The term fiduciary in the investment advisory world means that financial and retirement advisors are to act in the best interests of their clients. In other words, advisors are to put their clients' interests above their own. The goal is to protect investors from advisors who are concealing any potential conflict of interest.

For example, an advisor might have several investment funds that are available to offer a client, but instead only offers the ones that pay the advisor a commission for the sale. The conflict of interest is an agency problem whereby the financial incentive offered by the investment fund prevents the advisor from working on behalf of the client's best interest.

The agency problem may also be minimized by incentivizing an agent to act in better accordance with the principal's best interests. For example, a manager can be motivated to act in the shareholders' best interests through incentives such as performance-based compensation, direct influence by shareholders, the threat of firing, or the threat of takeovers.

Principals who are shareholders can also tie CEO compensation directly to stock price performance. If a CEO was worried that a potential takeover would result in being fired, the CEO might try to prevent the takeover, which would be an agency problem. However, if the CEO was compensated based on stock price performance, the CEO would be incentivized to complete the takeover. Stock prices of the target companies typically rise as a result of an acquisition. Through proper incentives, both the shareholders' and the CEO's interests would be aligned and benefit from the rise in stock price.

Principals can also alter the structure of an agent's compensation. If, for example, an agent is paid not on an hourly basis but by the completion of a project, there is less incentive to not act in the principal’s best interest. In addition, performance feedback and independent evaluations hold the agent accountable for their decisions.

In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to make the company appear to have more money than what was actually earned. The company's executives used fraudulent accounting methods to hide debt in Enron's subsidiaries and overstate revenue. These falsifications allowed the company’s stock price to increase during a time when executives were selling portions of their stock holdings.

In the four years leading up to Enron's bankruptcy filing, shareholders lost an estimated $74 billion in value. Enron became the largest U.S. bankruptcy at that time with its $63 billion in assets. Although Enron's management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest.

Agency problems arise during a relationship between a principal and an agent. Agents are commonly engaged by principals due to different skill levels, different employment positions, or restrictions on time and access. The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way.

In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to make the company appear to have more money than what was actually earned. These falsifications allowed the company’s stock price to increase during a time when executives were selling portions of their stock holdings. When Enron declared bankruptcy, it was the largest U.S. bankruptcy at that time. Although Enron's management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest.

While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk, known as agency cost, associated with it. Principal-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. Another method is to incentivize an agent to act in better accordance with the principal's best interests. For example, if an agent is paid not on an hourly basis but by the completion of a project, there is less incentive to not act in the principal’s best interest.

Which of the following makes the principal

What following might be an example of principal

What factors create principal

Which of the following is an example of the principal