The Principal – Agent

Problem
• Caused due to – Information Asymmetry
– Conflict of Interest
• Results in – Agency Costs
Examples:
Shareholders (principle)
vs.
Management (agent)

Financial institutions
Voters (principle)
(principle)
vs.
vs.
Politicians (agent)
Rating Agencies (agent)
Principal – Agent Problem in Private
Enterprises
• Most large firms – Controlled by management
• Information Asymmetry – Managers can pursue their own objectives

• Limitations to manager’s ability to deviate:

- Stockholders can complain
- Takeover attempts by other firms
- Market for managers who maximize profits
CEO Salaries: In Comparison with Revenues and
Profits
Increase in % in last 5 years

180 161
160
140
120 106
100 85 93 89
76 80 83 81
80 61 68 60
60 48 45 51
41 39
40 28 28 25
18
20
0
S&P BSE 500 Auto FMCG Engineering IT Healthcare Construction
Materials
Pay Revenues Profits
Solutions to Principal – Agent Problems
• Contract Design: To address issues of information asymmetry

• Performance Evaluation and Compensation:

- Designing a reward system
- Must be linked to performance
- Providing Financial Incentives