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Monday, 9 April 2012

Principal-Agent Problem

The divorce/separation of ownership and control helps explain the principal/agent problem.

Among large firms, the managers and the owners of the company tend to be separate. One who has the financial capacity to invest into a company (in extreme cases this can be through inheritance, lottery..) can do so without running it. This is the separation of ownership and control.

Because the owners are different to those who run the company (the managers), they may have different objectives. Managers want to benefit from perks (e.g. company car contribution, pension contribution, discounted gym membership) and bonuses. Owners want to maximise shareholder value. They also want to satisfice: achieve minimum targets that are acceptable and satisfactory to all member groups of the coalition that make up the firm. Satisficing helps resolve the conflict bought by the separation of ownership and control because in order to achieve ‘minimum’ targets, both parties must compromise. For more on satisficing, click here.

The principal-agent problem is the conflicting objectives of the owners and the shareholders of the company.

How does the principal-agent problem affect a firm?

The owner can never be sure that the employed managers are aiming to maximise profits or succumb to the temptation of maximising their own benefits, possibly leading to decreased profitability.

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