He asks tenants to take care of the property and minimise electricity bills. But, tenants may open windows rather than turn down the heating. Sub-contracting your essay. Suppose a lazy student paid a random stranger on the internet to write a dissertation.
Apart from being cheating which could lead the student to be expelled, it is also an example of a principal-agent problem. The principal-agent problem can also lead to an individual taking an excessive risk because the ultimate cost is borne by someone else. This is an example of moral hazard. For example, an investment banker may gain a bonus for making high profits. This encourages the banker to take risky investments.
This has led to major banking collapses, such as rogue trader Nick Leeson and Barings Bank Agency costs. Due to information asymmetries, principals may be unaware of how much a contract has been fulfilled. Principals may be reluctant to enter into a contract at all for the fear that they will not know what is going on. For example, a landlord may be reluctant to lend if he fears that a tenant may mistreat his property and be unable to know how it is cared for. If both parties to the relationship are utility maximisers, there is good reason to believe that the agent will not always act in the best interests of the principal.
Principal-agent problem enables agents to produce sub-optimal work. For example, managers may be profit-satisfiers — leading to higher costs and less profit. To try and overcome the principal-agent problem, the principal will have to spend money on monitoring and providing incentives for workers. Waiters who rely on tips for pay will have their interests more aligned with owners principals.
This can be an effective way to remove the principle-agent problem. However, due to social conventions, it is difficult to move away from tipping in all but the limited industries of restaurants and cafes. Performance Related Pay. A simple solution to give agents an incentive to work hard. However, it depends on how Performance Related Pay is implemented. Without sufficient flexibility, it can create tension in the workplace and reduce co-operation. Also, some jobs are suitable for objective evaluation, e.
But, other jobs, such as teaching and managers require more subjective evaluation. Different workplace environment. Workers are motivated by a variety of factors other than pay. Some of the main motivations are not pay, but pride in work and a sense of achievement. A management structure which encourages independence and workers taking responsibility for work can be more effective than crude pay bonuses. Shareholder and manager For example, a shareholder principal wants to maximise profits for his firm.
Market failure The principal-agent problem can lead to market failure because the agent pursues his own self-interest rather than that of the principal and the business may be run in an inefficient way. Requirements of principal-agent problem Multiple actors who have a different set of objectives e. Asymmetric information the agent having more information than principle. Examples of Principal-Agent Problem Shareholders and managers of a company. Principal-Agent Problem and Moral Hazard The principal-agent problem can also lead to an individual taking an excessive risk because the ultimate cost is borne by someone else.
Costs of Principal-Agent Problem Agency costs. However, due to social conventions, it is difficult to move away from tipping in all but the limited industries of restaurants and cafes Performance Related Pay. Related Market Failure Objectives of firms.
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The idea behind too big to fail is that some companies become so significant and critical to the economy, that no matter what they do, the government will bail them out. The principal-agent problem is also an example of market failure. Market Failures occur when there is a misallocation of resources, which results in distortions in the market. This distortion creates an inefficiency in the market. There are four probable causes of market failures; power abuse a monopoly or monopsony , the sole buyer of a factor of production , improper or incomplete distribution of information, externalities and public goods.
Explore Blog Reference library Collections Shop. Share: Facebook Twitter Email Print page. Principal s are owner s of the business with a significant equity stake They hire an agent such as a sales or finance manager to make day-to-day decisions affecting the business Managers may have different business objectives such as revenue maximization or sales maximisation Overcoming the Principal Agent Problem What is in the best interest of the management is not necessarily the same as the optimum interests of shareholders.
Employee share ownership schemes: For example, John Lewis and Waitrose have a well-regarded partnership model. Another example, in , the founder of Richer Sounds, handed over control of the firm to his staff. However, offering stock options might lead to perverse behaviour among employees — for example, deliberate attempts to hike up share prices through illegal action think back to the notorious case of the US energy company Enron. Long term employment contracts for senior management: Security of tenure might encourage managers to take pricing and investment decisions in the long-term best interests of the business rather than for short-term profit.
Long term stock commitment : Apple requires senior executives at Apple Inc.
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