Principal-Agent Problem

What is principal-agent problem?

Meaning of principal-agent problem: – The principal-agent problem is a conflict in priorities between an individual or group and the representative authorized to represent them and act on their behalf. The agent may act in a manner contrary to the interests of the principal. A discrepancy in interests between a person or group of people and the official approved to act on their behalf is known as the ‘principal-agent problem’.

Principal-Agent Problem

The principal-agent dilemma is as diverse as the principal and agent functions. It can happen in any case where the holder of a resource, or a principal, transfers sole control of the investment to a third party, or an agent.

The problem can occur in many situations, from the relationship between a client and a lawyer to the relationship between stockholders and a CEO.

For Example: – Stock holders, are principals who depend on the business’s chief executive officer (CEO) to work out a plan in their economic interest as their representative. In other words, they want the stock to rise in value or pay dividends, or even both. The principals may feel betrayed by their agent if the CEO chooses to invest all earnings in development or pay large salaries to managers.

The principal-agent problem can be solved in a variety of ways, but all of them include setting clear goals and keeping track of outcomes. In certain cases, the principal is the only one who can or can solve the problem.

What is Agency costs?

Meaning of Agency costs: – The risk that the agent will act in a way that is contrary to the principal’s best interest can be defined as ‘agency costs’. The principal, technically, cannot keep an eye on the agent’s activities. The risk that the agent will exceed the obligation, make a wrong decision, or otherwise act in a way that conflicts with the principal’s interest can be defined as the ‘agency costs‘. Dealing with an issue that occur as a result of an agent’s behavior can lead to additional agency costs. Agency charges are included in transaction fees.

Principal Agent Problem | Agency costs

Agency costs may also include setting costs or other incentives to encourage the agent to act in a certain way. Principals are willing to bear these additional costs as long as the expected increase in the return on the investment from hiring the agent is greater than the cost of hiring the agent, including the agency costs. They may employ external monitors or auditors to keep track of data. In the worst-case scenario, they will be able to take over as boss.

More examples:

Beyond the world of finance, the principal-agent problem can arise in a variety of everyday circumstances. A customer that employs a lawyer will be concerned that the attorney may charge for more time than is required. A homeowner may object to the City Council’s expenditure of public funds. A buyer of a home may believe that a realtor is more concerned with earning a commission than with the buyer’s concerns.

In both of these situations, the principal has no alternative. To complete the task, an agent is needed.

What is constrained decision making?

Meaning of constrained decision making: – Anything that limits a company’s operations is referred to as a restriction. The company will face a variety of constraints, and the mixing strategy will display all of them on the same schematic, allowing the decision-maker to choose a set of inputs that fits within the organization’s constraints while still achieving their goals. Therefore, the decision-making problem faced by a manager is one of constrained decision-making.

A managerial entrepreneur’s job is to solve problems with business practices. The resources at a company’s disposal are limited.

As a result, the best approach to the business decision-making problem demands that assets be used in such a way that the goal is met effectively.

One form of restriction that a firm’s manager faces is a restricted supply of capital.

The economic climate, which involves the state of the economy, the process of market cycles, rivalry from rival companies, state monetary and fiscal policies, importing and exporting policies, and so on, imposes another form of restriction on a firm’s manager. The manager must make business decisions in light of these restrictions. As a result, a manager’s situation dilemma is one of constrained decision-making.

In order to accomplish the goal, a decision-making challenge necessitates a choice between alternative actions. Market plans are the alternate courses of action from which a decision must be taken.

A real life example: –

Consider the automobile manufacturer Maruti Udyog Limited. Assume it has developed two potential courses of action (commonly referred to as strategies) to meet the consumer demand for its goods. The first action to take or policy is to prepare for internal expansion projects. The second option is to acquire Premier Auto Limited and use its capacity to raise production in order to meet rising demand for the company’s product.

The aim of Maruti Udyog Limited is to maximize income (that is, the market cap of expected returns) from increased production. Let S1 denote strategy 1 or the first plan of action (i.e., growing institutional capabilities), and S2 denote strategy 2 or the next way to proceed (i.e., acquiring the other firm).

The following final model can be used to choose between the two alternative strategies: –

  • If the profits from strategy S1 are greater than the profits from plan S2, choose strategy S1.
  • If the profits from S2 are greater than the profits from S1, select approach S2.

The above small explanation only highlights the most important aspect of the decision-making dilemma that business executives face, as well as the rule for solving it rationally. It is necessary to remember that managers must have a basic understanding of economic theory in order to formulate the optimization problem and reach at the selection method for selecting a policy or plan of action.

Microeconomics and macroeconomics are the two main divisions of modern economics. Microeconomics is associated with the concept of personal decision, including customer and company firm choice. Macroeconomics, but at the other side, is concerned with the analysis of the economy as a whole its agglomerates, such as GNP, the price level, and job levels. Executives or reasonable entrepreneurs benefit from both microeconomics and macroeconomics when making business decisions, but microeconomic theory principles and techniques are more useful to them.

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