7.7.5—Principal-agent problem

A principal-agent problem occurs when a principal delegates a decision to an agent whose actions are difficult to observe and whose incentives may differ. Managers may pursue sales, status or job security rather than owners’ profit.

Monitoring, performance pay, ownership stakes and clear contracts can align incentives, but they also have measurement costs and may encourage gaming. Information asymmetry is central.

A manager may favour an acquisition that increases the firm’s size and prestige even if its return is weak; a long-term return measure can make the incentive more consistent with owners’ objectives.

The problem is not simply “managers are bad”; it is created by delegated control, imperfect information and incentive design.