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The Principal-Agent Problem

The Principal-Agent Problem. Ownership & control: “the large corporation is owned by so many shareholders that no single shareholder owns a significant proportion of the outside stock. Therefore no single shareholder has the power to really control the actions of the officers of the corporation”.

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The Principal-Agent Problem

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  1. The Principal-Agent Problem • Ownership & control: “the large corporation is owned by so many shareholders that no single shareholder owns a significant proportion of the outside stock. Therefore no single shareholder has the power to really control the actions of the officers of the corporation”. • “Negligence and profusion … must always prevail in such a company.”

  2. The Principal-Agent Problem • The bulk of the dividends go to outside shareholders. • All the major decisions are taken by the corporate officers. • The outside shareholders are unable to control the corporate officers. • The interests of the shareholders and the corporate officers diverge significantly.

  3. The Principal-Agent Problem • Shareholders: PROFIT • Corporate Officers: POWER, PRESTIGE, PERSONAL WEALTH • Senior managers may be in a position to enrich themselves at the expense of the shareholders.

  4. Sales revenue maximising with a profit constraint £ TC TR P O Q Q3 Q1 Q2 Total profit

  5. ALTERNATIVE MAXIMISING THEORIES • Sales revenue maximisation • equilibrium output and price • comparison with profit-maximising output and price • effect of a minimum profit constraint • implications for advertising • comparisons with short-run profit maximising • implications for the consumer • assessment of the theory

  6. ALTERNATIVE MAXIMISING THEORIES • Growth as a motive for firms • growth maximisation • means of achieving growth • Growth by internal expansion • sources of funds • the takeover constraint • Growth by merger and take over • types of merger • merger activity

  7. Agency Theory • Agency theory in its simplest form discusses the relationship between two (or more) people, a principal and an agent who makes decisions on behalf of the principal. • Owners of firms and their managers. • Patient-doctor. • Managers and their subordinates.

  8. Agency Theory • All agency relationships involve moral hazard. • “the principal and the agent may have different objectives and the principal cannot easily determine whether the agent’s reports and actions are being taken in pursuit of the principal’s goals or self-interested behaviour.”

  9. Agency Theory • Informational Asymmetry • Monitoring • The Free Rider Problem

  10. External Constraints on Managers • The Product Market • The Market for Corporate Control • The Market for Managerial Labour

  11. Internal Control Mechanisms • Performance Related Pay • concentrates the risk of agents • promotes short term profit • share options schemes are asymmetric • compensation committees • size does matter

  12. Additional Control Mechanisms • The Board of Directors • Multiple Principals - the Role of the Banks • Managerial Bonding: the Role of Debt

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