Principal-agent theory
If you (the principal) hire a gardener (your agent) to mow your lawn while you are away, all you can observe is how the lawn looks when you come back. He could have mowed it every ten days, as you agreed, or he could have waited until two days before you were due home and mowed it only once. By prevailing on a neighbour to monitor your employee's behaviour, you could find out what he actually did, although at some cost.
When you hire a solicitor, however, it is almost impossible for you to monitor her effort and diligence on your behalf. You have not studied law, and much of what the solicitor does will be a mystery to you.
This latter situation is close to the relationship that exists between shareholders and managers. The managers have information and expertise that the shareholders do not have-indeed, that is why they are the managers. The shareholders can observe profits, but they cannot directly observe the managers' efforts. To complicate matters further, even when the managers' behaviour can be observed, the shareholders do not generally have the expertise to evaluate it. Everyone can see the firm's revenues, but it takes very detailed knowledge to estimate how large those revenues could have been if the managers had acted differently.
Boards of directors, who represent the firm's shareholders, can acquire some of the relevant expertise and monitor managerial behaviour, but again this is costly.
These examples illustrate the principal-agent problem. This is the problem of designing mechanisms that will induce agents to act in their principals' interests. In general, unless there is costly monitoring of agents' behaviour, the problem cannot be completely solved. Hired managers (like hired gardeners) will generally wish to pursue their own goals. They cannot ignore profits, however, because if they perform badly enough they will lose their jobs. Just how much latitude they have to pursue their own goals at the expense of profits depends on many things, including the degree of competition in the industry and the possibility of takeover by more profit-oriented management.
The principal-agent problem arises within the firm when ownership and control are separated and the self-interest of managers may lead them to act other than in the interest of the shareholders. The problem is to design monitoring or incentive systems that will make managers act in the best interest of the shareholders.
The principal-agent problem in the context of employers and employees more generally is discussed in later chapters.
Solutions to the principal-agent problem The way in which agents can be encouraged to act in the interest of principals is by the introduction of incentives to align the goals of the two. There are at least three ways in which this is done in firms today.
The first way to align the interests of shareholders and managers is to ensure that managers themselves have an interest in the value of the shares. This can be done either by ensuring that managers buy (or are perhaps given) some shares or by giving them share options which will create wealth for the managers when the value of the firms' shares rises above some value. Box 9.2 provides some further discussion of this issue. Some companies encourage a wide range of their employees to buy shares in the company via company savings schemes, in order to give these employees an interest in the profit of the company and not just in their own wage.
A second way to give managers a shared interest in profit is by tying some part of their remuneration directly to the firm's profits. This could be an annual bonus that is linked to the previous year's profit of the company as a whole, or it could be some explicit share of the profit of the part of the company in which that manager works.
A third way of achieving the same goal is to make promotion subject to the profits of the company as a whole or to the section in which the person is employed. Those who succeed in increasing profits in their divisions thus will get on well, and those who fail to do so may be let go.
