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The Principal Agent Problems In Organizations Economics Essay

Paper Type: Free Essay Subject: Economics
Wordcount: 3277 words Published: 1st Jan 2015

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The significant discussion in business economics is principal-agent problems in organizations. A principal is a top authority who hires agents to act on his/her behalf, while an agent usually aims to achieve the objectives of the principal. A principal-agent problem arises when the activities of an agent impact on the principal’s interests (Rabin, 2003). Although agents may seek to attain the goals set by principals but may sometimes fail to carry out those targets. The conflict between shareholders (as principals) and managers (as agents) is a good example of principal-agent problem (Jensen, et al., 1990). Griffiths and Wall (2007) suggested that when ownership and control is divided between the principals and agents in an organisations this gives the agents opportunity to pursue the goals that may not agree with the desires of the principals.

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A lot of principal-agent relationships may be found in human society such as patients and doctors, shareholders and managers, managers and workers. But shareholder – manager and manager – workers are the common principal-agent problem relationships in a business organisation and so this essay will concentrate on that aspect. Also, this essay will critically examine what principal-agent problems that take place in organizations and how the problems can be overcome. Principal-agent problem such as the asymmetry of information, moral hazard, adverse selection, employer and the employee, and

lack of motivation. Also, the theories of profit and sales maximization will be discusses. Finally, the solution on how this principal – agent can be overcome will be discussed such monitoring, flexible working hours, incentives, division of labour and delegation of authority, part ownership, long term contract, facilitation and support, efficiency wages.

Principal Agent problem

Asymmetric of information

One of the main principal agent problems which arise in organisations is asymmetric of information between principals and agents (Philp, et al., 2009; Shy, 1995), where shareholders and managers have different attitudes toward the task. Asymmetry of information means that one faction in an economic relationship has more information than the other (Sloman, 2007). This is a situation where the managers have more information than the owners. Managers may have information that is not completely accessible to the owners, as a result of this, managers would easily make decisions in their own interest, rather than in the interest of the principal (Griffiths and wall, 2007). In most companies, shareholders cannot inspect everything that managers do because, managers have full information that is only partly available to shareholders. Pindyck and Robert (2005) say that, if monitoring the productivity of managers were costless, the shareholders would make sure that their managers were working effectively. For example, in a limited liability company, asymmetric information would be a situation whereby the managers due to their expertise possess relevant information than the owners in the day to day operations of the business. Hence, the managers may pursue their own objectives than the owners’ goals (Chrystal and Lipsey, 1997). They both may have common objectives to be achieved. But the problem is that they have different level of experience. Therefore, shareholders and managers consign their own ‘probabilities to the realizations’ (Shy, 1995).

Moral hazard problem

Another principal agent problem that occurs in an organisations is the moral hazard problem. This occurs where the agent has best and excellent information to that which is available to the principal. Due to this hidden information by the managers, it may then be hard to monitor by the owners (Griffiths and Wall, 2007). However, moral hazard problem view from another way, is problem to any change of behaviour that takes place once a contract for the performance of some service has been agreed upon. For instance, a worker that worked well during his probationary period but, later change because he has been offered a permanent contract. Also in a limited liability company, when a managers prepare and report the financial information at the end of fiscal year. Ability for the shareholders not to able to understand and interpret the report prepared by the manager will not make the shareholder to know if the managers have acted accordingly to the company interest or owners interest, (Chrystal and Lipsey, 1997). Page (1997) point out that moral hazard problem arises when the owners of a business cannot directly control the managers action

Adverse selection

Adverse selection is also principal – agent problem which is on the part of the owners. This problem arise when the shareholders have trouble in identifying the character of the managers who get to perform on their behalf. Because of not be able to identify this make it difficult for shareholders to measure quality within the industry. An example of adverse selection was given by Griffiths and Wall, (2000) as situation whereby the manager have access to a privy information in which the owner is not. Consequently, there is no way by which the owner can know whether the manager performed well and to the best interest of the owner. This problem of adverse selection arises due to the lack of information concerning the value of a constraint specifying the managers characteristics (Page, 1991). In moral hazard, the shareholders are assumed to be informed concerning the managers attributes and function, while in adverse selection the shareholders does not know the agents characteristics (Sobel, 1993). Lipsey, (1997) says that adverse selection is a problem because the actual characteristics of the manager are not obvious to the shareholders immediately. McAuliffe, (1999) say that ‘adverse selection’ is a major cause of principal-agent problem. The selection of activities is always often different between shareholders and managers that brings about principal-agent problem in an organisation.

Employer and the employee

Principal agent problem in organisations is not only limited to shareholder and manager, it also occurs between the employer and the employee. This occurs when the workers avoid work because the work is harmful to them, and if the employee lacks motivation in the work place the performance of the workers will be affected. Another problem of shareholders and managers is inconsistent risk choices. Shareholders can spread out risk across firms and to other investment (Arnold and Lange, 2004).

Lack of motivation

Finally, lack of motivation is another problem faced by organizations, motivation is in the centre point of principal-agent problems in an organisation . Wong, (2000) describes “motivation involves goal-oriented commerce with incentives”, while Rabey, (2001) thinks “motivation is a human response based on the stimulus within him/her in order to drive forward or stay behind”. Therefore, motivation is a key issue to achieve the organization’s goals. Since the success of an organization is not certain operating by the invisible hand, it is important for the principals and agents to be motivated according to the present situation of the organization. There are several maximizing theories of the firm which can be used to critically analyze the principles of optimization relating to the principal agent problem which are as follows.

Maximizing Theories

Short – run and Long – run profit maximization

The first principle of the firm is found on the theory of short-run profit maximization. However, several activities of firms may be inconsistent with this objective and yet may be consistent with the aim of long-run profit maximization (Sloman, 2007). The theory of long-run profit maximization would be a practical option to the short-run profit maximization theory. Long-run profit maximization assumes that managers aim to shift cost and revenue curves so as to maximize profits over a longer period of time. According to Pindyck and Robert, (2005), profit maximization is mostly based on the postulation that firms are owner controlled, whereas sales and growth maximization believes that there is a separation between ownership and control. Griffiths and wall, (2005) suggested that, managers may also have incentives to pursue objectives rather than maximizing the expected present value of profit.

Managerial utility maximization

Another important model in the alternative maximizing theories is the managerial utility maximization. It was developed by Williamson, (1963). Williamson opinion is that, as much as the desire levels of profit are attained, managers have the freedom to select what plan to pursue their aim. That is, they are free to carry out their own personal interests. Williamson also argued that managers’ interests are to maximize their personal utility. Williamson further expatiate by pointing out some issues that have an effect on a manager’s utility, such as salaries, job security, supremacy and professional excellence. Of all these factors, salary is the only one that can be measured directly, while the others can be indirectly measured. And, they performed better than traditional profit-maximization theory (Sloman, 2006). Williamson conducted some research to back his claims. His research showed that employees and benefits were reduced during the period of recession and these increased during boom. A hypothetical example would be the current global recession which is affecting most economies of the world. In these economies, staffs and benefits has been drastically cut down. Subsequently, this has increased the number of people in the labor markets of these economies. However, Williamson’s model has been criticized and it is difficult in putting the model into test, that is, it is difficult to identify and obtain information on managerial slack, discretionary investment and staff expenditures. Philp et al. (2009).

Sales revenue maximization

This is the most popular theory and was publicized by Baumol, (1959). He suggested that if firm is been control by managers it will be to the benefit of sales revenue maximization rather than profit maximization. Williamson, (1963) is also in the supports Baumol by laying emphasis on the growth of sales revenue as a major firm objective. Griffiths and wall, (2007) pointed out that finance for more expenditure can come from income, external finance and sales revenue and they conclude that Williamson and Baumol are describing the same thing in different terms. Therefore, sales revenue maximization may be the key objective in the firm than profit maximization, especially if the firm has an effective functional sales department (Sloman, 2006). The diagram below shows Baumol’s, (1958) model of sales revenue maximization

Diagram A : Baumol’s, (1958) Model of Sales Revenue Maximization.

From the above “diagram A”, where TR is at maximum, 5 units of output will be produced by the firm, which will make sales revenue to be £140. However, the firm would produce at the profit maximizing level of output 4 units, while the sales revenue would be lower at £130. Therefore, sales revenue maximization is often in contrast with profit maximization (Griffiths and Wall, 2007). Baumol and Williamson identified that some level of control can be applied by shareholders on manager and the theory is known as the constrained sales revenue maximization. The highest sale revenue is always above the output level which is maximum profits (Griffiths and Wall, 2007).

How principal – agent problems can be overcome

There are different ways in which principal – agent problem can be overcome, which include monitoring, flexible working hours, incentives, division of labour and delegation of authority, part ownership, long term contract, facilitation and support, efficiency wages, which are discuss below:


Shareholders must establish a way of monitoring the performance of their managers. They might make use of the services of experts to examine carefully the operations of their managers by employing sovereign consultant to look into the managerial activities and also satisfactory models might then be implemented (Griffiths and wall, 2007).

Flexible Working Hours

Working hours issue might be a reason of dissatisfaction between agents and principals, especially between workers and managers. Presently lifestyle has greatly changed; so people expect more indulgence (time for family, holidays). If workers are not flexible in their working hours, they might lose their concentration to work. Workers might not focus on the owner’s benefit, as they are not happy with the working contacts. Thus this situation can lead to a poor output for the firm. Moreover, the usual relationship between managers and workers could be bitter because of the differences between their own expectations. In many firms, flexible working is being considered as a ‘key contributor to business success’ (Thomson, 2008). So organizations should be interested to introduce family friendly policies that will allow employees to choose their own flexible working hours. According to his research that flexible working is directly related to the business benefits. The organizations that offer flexible working hours for employees tend to have increase in productivity.


Shareholders can institute the use of incentives so that the managers will behave in ways that are consistent with the shareholders interests such as incentives pay which is a good way of solving the principal – agent problem affecting firms. This motivates the workers to strive for profitability and managers are given incentives to motivate them so also do the workers need to be given incentives too. Incentives inform of performance bonus, end of year target, profit sharing or projecting a target for the workers and basic increment of salary and promotion to the profit of the firm inform of annual bonus which will depend on achieving the speculated target. (Sloman, 2007).

Division of labor and delegation of authority

More managers should be employed to supervise workers. So that individual workers will have manager to report too, which will gives each managers to be able to supervise their workers thoroughly. Workers (agents) are rational utility maximizes and these utility depend as they do more work for a given weekly wage. There are situation which workers tend to reduce their work if they are not closely monitored by their managers (principals) (Parkin et al, 2000).

Part ownership

If workers are given sense of ownership like, opportunity to participate in decision making and having their own shares in the firm, this will make them to see themselves as owners but not workers, by conveying to a worker part ownership of a business, the owners can encourage a performance that would increase a company’s profits (Parkin et al, 2005). Part ownership is a good method of solving the principal-agent problem between owners and managers and managers and workers (Stiglitz, 1993).

Long term contract

This is another way to overcome principle agent problem, the owners of a business can attach the success of the business to the long term wealth of its managers. For instant, managers which are offered a long term contract with a company, doing this will encourage the manager to develop strategies that will make him / her to achieve profit maximisation in the long run (Parkin et al, 2005).

Facilitation and support

In this situation management can give support to help employees to deal with their fear and anxiety during transition periods. The managers can give departmental reward on behalf of the shareholder to workers which perform well in particular department, such reward can be inform of monetary, promotion, and this will create competition for other worker in the department and other departments. And shareholders can reward managers also by giving encouraging words (Tirole, 2007).

Efficiency Wage

These show the problem in getting the ability and amount of employee achievement. Way to admonish employee from avoiding their duty is by giving wages over – equilibrium, with this, the fear of been sacked by the manager seeing them avoiding there responsible is bigger.

Diagram B below shows demand and supply for labour. Increase in wages make labour demanded to reduce, also increase in wages tend to increase in labour supplied. Therefore, the quantity of labour demanded will be adequate to the quantity supply. Giving efficiency wages, over equilibrium wage rate, the labour market is cast into disequilibrium. Efficiency give rise to unemployment problem but the main reason of efficiency wages is to make the agent to communicate with the principal. The diagram below shows that as wage increases from 6 to 8 less labour will be demanded at quantity 4. Also, as wages rise more labour would be supplied at quantity 8. In equilibrium, the quantity of labour demanded will be equal to quantity supplied and unemployment will be eliminated. However, by paying efficiency wage above the equilibrium wage, there would be disequilibrium which would lead to unemployment in the labour market (Philp et al, 2009).

Demand and Supply for Labour














1 2 3 4 5 6 7 8 9


Diagram B. Efficiency wage (Philp et al, 2009).

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From the above point discussed regarding principal-agent problems, it can be concluded that most firms have multi-sections and a variety of productions, therefore, owners of firms employ agents (managers) to operate the business on their behalf (owners). In order to overcome the principal agent problems in organisations, the shareholders and the managers need to be fully informed and have the same objectives and goals. motivation is important for both principals and agents and doing this will instigate them to work more and also if worker are part of ownership the employees might be inspired to work hard to accomplish the company’s targets. And the best way to motive worker is by introducing incentive to acknowledge employees’ achievements and this is significant for the success for the business. Moreover incentive may keep employees out of moral hazard.

Long-term service contact is essential and this give employee job security. Flexible working hours not only can convince the workers but also important for the successes of firms. So therefore, principals need agents to accomplish the objectives on their behalf, whereas agents may wish to continue the service of principals and both are interdependent of each other. So both principals and agents should concentrate on their responsibilities toward others and that can help t to overcome principal – agent problems to a larger extend.


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