Ownership, control and the principal-agent problem

Overview

Divorce of ownership from control, principal-agent problem in the context of a company and asymmetric information central to the principal-agent problem.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is meant by the divorce of ownership from control?

   Model answer

   It describes the situation in a large company where the shareholders who own the business are not the managers who run it. Ownership is spread across many shareholders, each with a small stake, while day-to-day and strategic decisions are taken by salaried directors and managers. The two groups have different interests and different information, so decisions may not reflect what the owners would choose.

2. 2

   Why does the divorce of ownership from control arise as firms grow?

   Model answer

   A large firm needs more capital than any individual can supply, so it raises finance by selling shares to many investors. It also needs specialist management skills that the original owners may not possess. The result is a wide body of shareholders who supply capital but neither wish nor are able to run the business, and a professional management team that runs it without owning much of it.

3. 3

   What is the principal-agent problem in the context of a company?

   Model answer

   The shareholders are the principals, who want the value of the firm maximised, and the managers are their agents, engaged to act on their behalf. The problem is that the agents have their own objectives, such as salary, security, status and a quiet life, and the principals cannot observe everything the agents do or fully judge whether poor results reflect bad luck or low effort. Agents can therefore pursue their own interests at the principals' expense.

4. 4

   Why is asymmetric information central to the principal-agent problem?

   Model answer

   Managers know far more than shareholders about the firm's opportunities, costs and their own effort, and shareholders see only the outcome. Because a poor outcome can be blamed on market conditions, shareholders cannot reliably infer whether managers worked hard or made good choices. Without that information they cannot write a contract that rewards effort directly, so managers retain discretion.

5. 5

   Analyse three decisions a manager might take that serve the manager's interests rather than the shareholders'.

   Model answer

   A manager might expand the firm through acquisitions that raise the size of the empire and the manager's salary while paying more than the acquired assets are worth, so shareholder value falls. A manager might avoid a profitable but risky project because failure would threaten the manager's job, even though diversified shareholders would want the risk taken. A manager might also spend on prestige headquarters, corporate hospitality and extra staff, all of which raise costs without raising output.

6. 6

   Why might managers be more risk-averse than shareholders?

   Model answer

   A shareholder can hold a diversified portfolio, so the failure of one project in one company has a limited effect on total wealth. A manager's career, reputation and income are concentrated in a single firm and cannot be diversified, so a failed project can be personally devastating. Managers therefore reject some risky projects with a positive expected return that shareholders would want undertaken.

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