The a tendency to focus in the

The principal-agent problem refers to the dilemma that
occurs upon stakeholders (principals) hiring directors (agents) to make
business decisions on their behalf. The general idea holds that the managers
will have a tendency to focus in the short term life and growth of a company in
a way that will increase their personal wealth, whereas shareholders wish for
the company to be run in the manner which will most efficiently increase
shareholder value (brought about by management making wise investment decisions,
increasing both the value of shares and dividends paid out). Thus the dilemma
results from a divergence of interests, as well as from asymmetricity of information
concerning the actions of those to whom control has been devolved to. This
dilemma is problematic because shareholders who disagree with the management
decisions of a director will be less willing to hold shares in the company in
the long term. A smaller company is far less likely to have such issues, as
they will tend to have a much lesser extend of divorce between ownership and
control.  As a result of agency costs, the
shareholders of the company cannot know exactly to what extent the terms of the
contract are being fulfilled, or how hard the manager is actually working. This
problem may lead to a market failure, a situation that arises from an
inefficient allocation of scarce resources, as a result of the hired director
pursuing self-interest rather than what is best for the health of the business.
This dilemma occurs partially due to adverse selection, a situation where, for
example, the principle is unaware of certain characteristics of an agent at the
time the contract is written. For example, the manager can easily hide his lazy
nature. It is impossible for the shareholders to know other very relevant
characteristics such as his costs of effort exertion or valuation of a
particular good. The principal agent problem can lead to excessive risk being
taken by senior managers, as the cost of the failure of investment decision is
absorbed ultimately by the firm and not the individual manager. This is
particularly frequent when the manager gains a bonus for achieving high profits
from the firm, all while having no stake in the company, as this gives managers
an incentive to take more high-risk decisions and veer away from safer
investment decisions. Asymmetric information may result in profit satisficing, a
practice whereby managers seek to simply satisfy the shareholder’s minimum specified
requirements, while maximising effort in more personal objectives such as
getting along co-workers and enjoying work in general.

The ideal contract to solve the issues arising from the
principal-agent problem would be a ‘complete’ one. A complete contract is one

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