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Agency problem and its solutions

Essay Topic: ,

Principal-agent relationship occurs when a principal contracts an agent. The principal hires the agent to perform a service for him or to act on his behalf. For example, in a large corporation, shareholders would hire managers to help them to organize the company in dairy business.

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However, agency problems may arise because of the conflict interest and asymmetry information between principals and agents, which lead to agency costs. In this essay, I would like to use the agency theory introduced by Jensen and Meckling (1976) to analysis that to what extent that agency cost would damage shareholder’s wealth maximisation and what actions shareholders could take to correct it.

Agency problems and main causes of it

First of all, there might to conflicts of interest or different goals between principals and agents, the agent would act as their best self-interest but not principal’s. Secondly, there is asymmetry information between principals and agents, managers may have more information than principals or they could hide their actions. Thirdly, there is uncertainty in the outcome. The outcome may not just depend on managers’ effort but also other factors like good luck or high market’s expectation lead to increase in share price.

Agency costs

Agency cost incurred when the managers do not attempt to maximise firm’s value and the cost to monitor manager and constrain their behaviours. Agency cost is the sum of three types of costs, cost of designing the contract, cost of enforcing the contract (monitoring and bonding) and residual loss if contract is not optimal.

Solutions of agency problems
Monitoring
Management compensation
Incentive compensation

There are two major principal agent model, adverse selection and moral hazard. Adverse selection occurs when one of the parties, usually the agent, has better relevant information prior to the contract. This hidden information will be used opportunistically to optimize the utility gained from entering the contract. In moral hazard the principal is unable to observe the agents actions after signing the contract. This causes the agent not to take the full consequences of his actions and thus he can use this hidden information to act opportunistically and maximize his own profit. In most cases the principal will have to carry the costs of this behaviour.