Principal-Agent Relationships occur whenever one person acts in the interests of another. Complex modern corporations have so many stakeholders that there are many simultaneous principal-agent pairings making it difficult to satisfy the needs of both obligatory and implicit agency relationships.
There is an agency relationship between employees of a firm and its owners. Suppose that to conduct normal business, an employee must travel necessitating the expenses associated with a hotel stay. If the owners of the organization allow the employee to arrange his/her own travel itinerary, an agency problem can occur if the employee spends more on the hotel than is necessary to conduct business. For example, if the employee books a 5-star hotel in a major city, takes advantage of expensive hotel services, and orders room service several times a day, the equity of the company’s owners is diminished because these high-cost expenses are not a necessary expenditure.
Agency problems are possible because of asymmetric information between the principal and agent. One of the results of the corporate structure is separation of control and ownership. Separation is the direct cause of asymmetric information. With an inability to monitor agents, the principle of self-interest suggests that agents will act in their own self-interest whenever possible.
To reduce the effects of asymmetric information, owners of a company will often incorporate monitoring to keep a closer eye on agents. Unfortunately, it is impossible to perfectly monitor an agent. Budgets, maximum spending limits, and proper accounting of monies all represent monitoring behaviors.
When monitoring procedures are incapable of perfectly monitoring an agent, a problem of moral hazard exists. No matter how much monitoring is in place there will always be opportunities for agents to behave unobserved. Policies that police all agent activities would be too costly to be useful. Often, the effects of agents working in their own self-interest are less of a cost than the monitoring costs. These unobserved self-interested behaviors are a kind of perquisite and although they represent a real cost, they do not satisfy the theory of incremental benefits for justifying prohibitive monitoring costs.
Moral hazards are created when agents can act unobserved in a self-interested manner. The costs of monitoring agents to avoid a moral hazard are often too high to justify the expenditure. Consequently, some loses due to an agent’s self-interested behavior can be expected as a normal cost of doing business. The incremental benefits of putting perfect monitoring in place usually does not outweigh the losses. Alternatives to monitoring can be in the form of incentives, bonuses, stock options, and commissions. These alternatives must be more attractive than the benefits of not acting in the interest of the owners for employees to favor the self-interest of obtaining them over creating a moral hazard.
This post is part of the series: Principal-Agent Relationships
- Defining Principal-Agent Relationships for Investment Purposes
- Principal-Agent Relationships and the Conflicts That Can Arise Within Them
- Principal-Agent Relationships: Agency Problems, Monitoring, and Moral Hazards
- Minimizing Agency Costs in Principal-Agent Relationships