Principal-Agent Relationship

What Is the Principal-Agent Relationship?

A principal-agent relationship is one in which one entity legally appoints another to operate on its behalf. In a principle-agent relationship, the agent acts on behalf of the principal and should not have a conflict of interest in carrying out the act. The connection between the principal and the agent is known as “agency,” and the law of agency defines principles for such a relationship.

Stockholders and Managers

A principal-agent relationship exists whenever one party hires another to act on its behalf. In the case of a corporation, such a relationship can occur:

An information asymmetry exists between the shareholders (principals) and the managers (agents) because it is difficult and costly for the shareholders to observe what the managers are doing and whether the managers’ actions are in the shareholders’ best interest.

Principal-Agent Problem
In fact, the interest of the managers do not always align exactly with the interest of the principals; this constitutes the principal-agent problem. In some cases, a firm’s managers will pursue their self-interests at the expense of the shareholders. For example, the shareholders’ interest is best served by efforts to maximize the current value per share of the corporation’s stock (i.e., wealth maximization). However, the managers’ self-interest may be best served by efforts to, for example:

Managers’ Self-interest may be Best Served by Efforts to:

• Spend money on perquisites (e.g. company cars, lavish offices)
• Make decisions independent of shareholders
• Increase short term profits to increase salaries
• Disguise poor performance through accounting tricks
• Pursue mergers and acquisitions motivated by desire for more authority or higher salaries

What Are Agency Costs And When Do They Typically Occur?

Agency costs are basically just any cost associated with hiring somebody else to do the work for you.

So, a practical example would be if you hired someone to mow your lawn or shovel your driveway, they might not do as good a job as you would yourself because they’re not as personally invested in the world.

Now where that applies to the corporate setting would be company shareholders hiring management and then management doing things that may or may not be in the best interest of the owners. Could be things like paying themselves high salaries or going on unnecessarily luxurious business travel or things like that.

So, it’s basically anything that the owners wouldn’t do themselves if they were there, but it’s taking place because they hired–had to hire somebody else to do the job for them.

Recommended for you The Finance Function

Review Checkpoint

To test your understanding of the content presented

1. The interests of what groups must be aligned if a corporation is to maximize shareholder wealth?Choose only one answer below.

a. Shareholders and Federal Agents

b. Managers and Board of Directors

c. Managers and Shareholders

Correct. Shareholders (principals) hire managers (agents) to run the business. To avoid the principal-agent problem, the interests of managers and shareholders must align.

d. Employees and Managers

2. Which of the following is an example of a principal-agent relationship?Choose only one answer below.

a. Corporate managers and shareholders

b. Managers and subordinates

c. Elected officials and Voters

d. All of the above

Correct. All of the relationships are examples of a principal-agent relationship. A principal-agent relationship exists whenever one party (the principal) hires another party (the agent) to act on its behalf.

Recommended for you Motivate Managers