What principal-agent problems arise in organisations? How can they be overcome?

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MSc Management                Business Economics

Business Economics Assignment

MSc Management & HRM

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(Excluding References); 3,285

What principal-agent problems arise in organisations? How can they be overcome?


The size and structure of many modern firms means that people, known as agents, are employed to carry out tasks and make decisions on behalf of principals (Strong & Waterson, 1987). The agent commonly has specialist knowledge and skills to carry out such tasks, and Sloman (2006) states that the existence of such relationships is evidence of increased specialisation and the division of labour in competitive firms. These relationships are known as principal-agent relationships, and Sloman (2006) claims they are prevalent among firms operating in today’s complex economy, and pose a wide range of problems. The following paper aims to investigate the difficulties that arise on the back of principal-agent relationships, and analyse the effectiveness of various solutions that firms employ. In managerial economics the orthodox mainstream view of the firm is known as the neo-classical model, and Crew (1975) illustrates that one of the key assumptions underpinning the model is that firms aim to maximise profits and ultimately attempt to optimise performance. Taking into consideration the complexity of today’s modern economy, the neo-classical model appears to display little resemblance to the reality of modern organisations. Crew (1975) describes how the mainstream view of the firm explores market relationships and relationships between organisations, but seems to ignore the internal structure of firms. This paper will therefore consider alternative theories of the firm that take into account the presence of internal relationships among modern organisations, and in particular will examine in depth the principal-agent problems that occur between shareholders and managers. Any problems that become apparent after studying the alternative models will then be investigated using empirical data. Solutions commonly adopted to overcome these problems will be scrutinized using empirical evidence also. The discussion will then briefly explore another principal-agent relationship, between employers and workers. The problem of ‘shirking’ will be considered as well as solutions that address the various problems that this different relationship throws up. Finally the paper will conclude by attempting to critically evaluate the effectiveness of the solutions used by organisations when trying to align the interests of the agent to that of the principal.


Building on the traditional profit maximisation model, Davies (1991, p.28) suggests “the objective of the firm is to maximise the wealth of its shareholders”. A key feature of mature capitalism is the existence of large organisations, which Berle and Means (1932) describe as having complex hierarchies and the distribution of shares leads to owners who do not take part in the day-to-day operations of the firm. Many academics have therefore argued that the firm cannot be viewed as a single entity, and Clarke & McGuinness (1987, p. 5) refer to the firm as a “coalition of individuals with conflicting interests”. Strong & Waterson (1987) describe how shareholders, acting as principals, employ managers, who are the agents, to act on the their behalf. Davies (1991) therefore concluded that the control of a firm had been taken away from the owners, and now lay in the hands of the managers. The principal-agent problem in this instance stems from information asymmetry between the shareholder and the manager, whereby the shareholder has less knowledge of the manager’s actions than the manager himself (Sloman, 2006). Moral hazard also arises as a result of the manager possessing economic power over his employer, therefore having some freedom to fulfil his own personal ambitions that, Clarke & McGuinness (1987) state, are likely to differ from the typical profit maximisation goals of the shareholder. The recent credit crunch and economic crisis is an example of the problems that principal-agent relationships can cause. Dillow (2008) explains how it was not the markets that failed, but the internal ownership of stock market-quoted companies with diffused shareholders. The collapse of large investment banks was due to the shareholders having little control over fund managers, who had little control over the CEOs, who in turn had little control over the trading desks. Dillow (2008) suggested this all stemmed from asymmetric information, as in reality it was only the traders who understood the complexities of mortgage derivatives, and it was the traders who were set to earn millions in bonuses at no real risk to themselves.

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As a result of the separation of ownership and control, many have claimed it is unrealistic to assume that firms will be concerned solely with maximising profits. In the late 1950s William Baumol  observed that manager’s salaries, status and remunerations were not so closely associated with profits, but were in fact linked to sales revenue. The performance of managers is often judged on sales revenue, and Sloman (2006) proposes that sales figures are often used as an indicator of an organisation’s condition. Baumol therefore suggested that managers were motivated by remuneration (from achieving large sales), and increasing the size ...

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