The principal-agent problem refers to the dilemma thatoccurs upon stakeholders (principals) hiring directors (agents) to makebusiness decisions on their behalf. The general idea holds that the managerswill have a tendency to focus in the short term life and growth of a company ina way that will increase their personal wealth, whereas shareholders wish forthe company to be run in the manner which will most efficiently increaseshareholder value (brought about by management making wise investment decisions,increasing both the value of shares and dividends paid out). Thus the dilemmaresults from a divergence of interests, as well as from asymmetricity of informationconcerning the actions of those to whom control has been devolved to. Thisdilemma is problematic because shareholders who disagree with the managementdecisions of a director will be less willing to hold shares in the company inthe long term.
A smaller company is far less likely to have such issues, asthey will tend to have a much lesser extend of divorce between ownership andcontrol. As a result of agency costs, theshareholders of the company cannot know exactly to what extent the terms of thecontract are being fulfilled, or how hard the manager is actually working. Thisproblem may lead to a market failure, a situation that arises from aninefficient allocation of scarce resources, as a result of the hired directorpursuing self-interest rather than what is best for the health of the business.This dilemma occurs partially due to adverse selection, a situation where, forexample, the principle is unaware of certain characteristics of an agent at thetime the contract is written.
For example, the manager can easily hide his lazynature. It is impossible for the shareholders to know other very relevantcharacteristics such as his costs of effort exertion or valuation of aparticular good. The principal agent problem can lead to excessive risk beingtaken by senior managers, as the cost of the failure of investment decision isabsorbed ultimately by the firm and not the individual manager. This isparticularly frequent when the manager gains a bonus for achieving high profitsfrom the firm, all while having no stake in the company, as this gives managersan incentive to take more high-risk decisions and veer away from saferinvestment decisions. Asymmetric information may result in profit satisficing, apractice whereby managers seek to simply satisfy the shareholder’s minimum specifiedrequirements, while maximising effort in more personal objectives such asgetting along co-workers and enjoying work in general. The ideal contract to solve the issues arising from theprincipal-agent problem would be a ‘complete’ one.
A complete contract is onewhereby