The significant discussion in business economics is principal-agent problems in organizations. A principal is a top authority who hires agents to act on his/her behalf, while an agent usually aims to achieve the objectives of the principal. A principal-agent problem arises when the activities of an agent impact on the principal’s interests. Although agents may seek to attain the goals set by principals but may sometimes fail to carry out those targets. The conflict between shareholders (as principals) and managers (as agents) is a good example of principal-agent problem. When ownership and control is divided between the principals and agents in an organisations this gives the agents opportunity to pursue the goals that may not agree with the desires of the principals.
A lot of principal-agent relationships may be found in human society such as patients and doctors, shareholders and managers, managers and workers. But shareholder-manager and manager-workers are the common principal-agent problem relationships in a business organisation.
Principal-Agent Problems in Business Organizations
1. Asymmetric of Information
One of the main principal-agent problems which arise in organisations is asymmetric of information between principals and agents, where shareholders and managers have different attitudes toward the task. Asymmetry of information means that one faction in an economic relationship has more information than the other. This is a situation where the managers have more information than the owners. Managers may have information that is not completely accessible to the owners, as a result of this, managers would easily make decisions in their own interest, rather than in the interest of the principal. In most companies, shareholders cannot inspect everything that managers do because, managers have full information that is only partly available to shareholders. If monitoring the productivity of managers were cost-less, the shareholders would make sure that their managers were working effectively. For example, in a limited liability company, asymmetric information would be a situation whereby the managers due to their expertise possess relevant information than the owners in the day to day operations of the business. Hence, the managers may pursue their own objectives than the owners’ goals. They both may have common objectives to be achieved. But the problem is that they have different level of experience. Therefore, shareholders and managers consign their own ‘probabilities to the realizations’.
2. Moral Hazard Problem
Another principal-agent problem that occurs in an organisations is the moral hazard problem. This occurs where the agent has best and excellent information to that which is available to the principal. Due to this hidden information by the managers, it may then be hard to monitor by the owners. However, moral hazard problem view from another way, is problem to any change of behavior that takes place once a contract for the performance of some service has been agreed upon. For instance, a worker that worked well during his probationary period but, later change because he has been offered a permanent contract. Also in a limited liability company, when a managers prepare and report the financial information at the end of fiscal year. Ability for the shareholders not to able to understand and interpret the report prepared by the manager will not make the shareholder to know if the managers have acted accordingly to the company interest or owners interest. Moral hazard problem arises when the owners of a business cannot directly control the managers action.
3. Adverse Selection
Adverse selection is also principal-agent problem which is on the part of the owners. This problem arise when the shareholders have trouble in identifying the character of the managers who get to perform on their behalf. Because of not be able to identify this make it difficult for shareholders to measure quality within the industry. An example of adverse selection was a situation whereby the manager have access to a privy information in which the owner is not. Consequently, there is no way by which the owner can know whether the manager performed well and to the best interest of the owner. This problem of adverse selection arises due to the lack of information concerning the value of a constraint specifying the managers characteristics. In moral hazard, the shareholders are assumed to be informed concerning the managers attributes and function, while in adverse selection the shareholders does not know the agents characteristics. Adverse selection is a problem because the actual characteristics of the manager are not obvious to the shareholders immediately. Adverse selection is a major cause of principal-agent problem. The selection of activities is always often different between shareholders and managers that brings about principal-agent problem in an organisation.
4. Employer and the Employee
Principal-agent problem in organisations is not only limited to shareholder and manager, it also occurs between the employer and the employee. This occurs when the workers avoid work because the work is harmful to them, and if the employee lacks motivation in the work place the performance of the workers will be affected. Another problem of shareholders and managers is inconsistent risk choices. Shareholders can spread out risk across firms and to other investment.
5. Lack of Motivation
Finally, lack of motivation is another problem faced by organizations, motivation is in the center point of principal-agent problems in an organisation. Motivation is a human response based on the stimulus within him/her in order to drive forward or stay behind. Therefore, motivation is a key issue to achieve the organization’s goals. Since the success of an organization is not certain operating by the invisible hand, it is important for the principals and agents to be motivated according to the present situation of the organization.
How Principal-Agent Problems can be Overcome in Organizations?
There are different ways in which principal-agent problem can be overcome, which include monitoring, flexible working hours, incentives, division of labor and delegation of authority, part ownership, long term contract, facilitation and support, efficiency wages, which are discuss below:
- Monitoring: Shareholders must establish a way of monitoring the performance of their managers. They might make use of the services of experts to examine carefully the operations of their managers by employing sovereign consultant to look into the managerial activities and also satisfactory models might then be implemented.
- Flexible Working Hours: Working hours issue might be a reason of dissatisfaction between agents and principals, especially between workers and managers. Presently lifestyle has greatly changed; so people expect more indulgence (time for family, holidays). If workers are not flexible in their working hours, they might lose their concentration to work. Workers might not focus on the owner’s benefit, as they are not happy with the working contacts. Thus this situation can lead to a poor output for the firm. Moreover, the usual relationship between managers and workers could be bitter because of the differences between their own expectations. In many firms, flexible working is being considered as a key contributor to business success. So organizations should be interested to introduce family friendly policies that will allow employees to choose their own flexible working hours. According to his research that flexible working is directly related to the business benefits. The organizations that offer flexible working hours for employees tend to have increase in productivity.
- Incentives: Shareholders can institute the use of incentives so that the managers will behave in ways that are consistent with the shareholders interests such as incentives pay which is a good way of solving the principal-agent problem affecting firms. This motivates the workers to strive for profitability and managers are given incentives to motivate them so also do the workers need to be given incentives too. Incentives inform of performance bonus, end of year target, profit sharing or projecting a target for the workers and basic increment of salary and promotion to the profit of the firm inform of annual bonus which will depend on achieving the speculated target.
- Division of Labor and Delegation of Authority: More managers should be employed to supervise workers. So that individual workers will have manager to report too, which will gives each managers to be able to supervise their workers thoroughly. Workers (agents) are rational utility maximizes and these utility depend as they do more work for a given weekly wage. There are situation which workers tend to reduce their work if they are not closely monitored by their managers (principals).
- Part Ownership: If workers are given sense of ownership like, opportunity to participate in decision making and having their own shares in the firm, this will make them to see themselves as owners but not workers, by conveying to a worker part ownership of a business, the owners can encourage a performance that would increase a company’s profits. Part ownership is a good method of solving the principal-agent problem between owners and managers and managers and workers.
- Long Term Contract: This is another way to overcome principle agent problem, the owners of a business can attach the success of the business to the long term wealth of its managers. For instant, managers which are offered a long term contract with a company, doing this will encourage the manager to develop strategies that will make him / her to achieve profit maximization in the long run.
- Facilitation and Support: In this situation management can give support to help employees to deal with their fear and anxiety during transition periods. The managers can give departmental reward on behalf of the shareholder to workers which perform well in particular department, such reward can be inform of monetary, promotion, and this will create competition for other worker in the department and other departments. And shareholders can reward managers also by giving encouraging words.
- Efficiency Wage: These show the problem in getting the ability and amount of employee achievement. Way to admonish employee from avoiding their duty is by giving wages over-equilibrium, with this, the fear of been sacked by the manager seeing them avoiding there responsible is bigger.