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Principal-Agent Relationships and the Conflicts That Can Arise Within Them

written by: John Garger•edited by: Michele McDonough•updated: 9/25/2010

Whenever one person acts in the interests of another, there are bound to be conflicts between the agent acting on behalf of the principal and working in his/her own self-interest. Learn about these conflicts from the point of view of an investor.

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    Principal-Agent Relationships exist whenever one person or party works in the interests of another party. Some of these relationships arise through obligatory contractual relationships and some can be informal or even hidden relationships that only reveal themselves at a point in the future.

    The set-of-contracts model of the modern corporation demonstrates that many stakeholders are affected, both formally and informally, by the corporate body. One of the moral problems managers of a firm face is which stakeholders to satisfy to keep the corporation profitable while at the same time remaining cognizant of the ethical dilemmas of maximizing shareholder wealth to the detriment of other stakeholders. Is the primary purpose of the principal-agent relationship to take into account only the owners’ interests? What would the owners think of reducing shareholder wealth to satisfy moral obligations to other stakeholders? The principle of self-interested behavior states that the managers of a firm will act in their own self-interest. What happens when acting in their own self-interest creates moral problems to both stockholders and stakeholders?

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    An Example of Principal-Agent Conflict

    Suppose a company enjoyed a particularly profitable quarter with record sales and retention of a large amount of cash from normal operations. This windfall is the direct result of the employees, the owners’ agents, who worked hard to maximize corporate and, consequently, shareholder wealth. The managers of the firm must decide what is the best use for the extra cash lying around as a liquid asset?

    The managers have decided that the money should be used for one of two purposes: employee wage increases to reward the hard work that created the extra income or a payment of a large dividend to the shareholders as a reward for investing the capital necessary to make the extra income.

    The principle of self-interested behavior would suggest that the stockholders would want the dividend option since it means more wealth for them. Employees, however, would prefer the wage increases for the same reason. The self-interest principle would also suggest that the managers making the decision would want the wage increases because it would mean more money in their pockets.

    This example illustrates the conflicts that can arise in principal-agent relationships. In fact, imagine that as an incentive to make the firm as profitable as possible, part of the managers’ compensation package includes shares of stock in the firm. The complexity of agency theory becomes clearer still because the managers will benefit from either a wage increase or a dividend distribution. The shrewd manager will do a little calculating to determine which alternative or combination of the two alternatives will maximize his/her self-interest.

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    Conflicts arise in Principal-Agent relationships when alternatives faced by the agent can affect his/her own personal interests. Some principals go to great lengths to monitor and limit the power of agents to ensure that the principal’s interests are properly adhered to. However, it is nearly impossible to monitor and limit the agent to a point where no conflicts are possible. In addition, these steps taken by the principal may limit the agent so much that he/she can not ensure that the interests of the principal are acted upon in a manner where positive outcomes are maximized.

Principal-Agent Relationships

Corporations have a multitude of Principal-Agent Relationships as the Set-of-Contracts view of the firm implies. Agency problems, monitoring, moral hazards, and agency costs are often evaluated by investors to determine the risk of owning stock in a corporation.
  1. Defining Principal-Agent Relationships for Investment Purposes
  2. Principal-Agent Relationships and the Conflicts That Can Arise Within Them
  3. Principal-Agent Relationships: Agency Problems, Monitoring, and Moral Hazards
  4. Minimizing Agency Costs in Principal-Agent Relationships