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Definition: Principal Agent Problem
Principal Agent problem arise when a principal (party1) chooses an agent (party2) to act on its behalf to take decisions. The agent may not always act in the best interest of the principal party and hence the problem context develops.
The party (principal) who hires another party (agent) to take decisions which will impact principal positively, pays some incentive to the agent in order to do so. But sometimes the agent may not act in the best interest of the principal because of a lot many factors which may be there, like if the principal has not clearly stated his interests or the agents interest differs from that of the principal. There are lots of scenarios in which principal agent problem arise. It is very common in the case of management and the shareholders where the management may be trying to increase the net profits of the company, while the shareholders wants to increase their own wealth by capital gains or dividends.
The principal agent problem in this case gives rise to the concept of agency cost. The principal here has to bear the cost of hiring the agent and paying the agent to act on its behalf. Sometimes the agent tend to gain from the asymmetric information between the agent and principal. Asymmetric information means that agent is better informed than the principal. Since the agent is better informed he may try to leverage the situation to make gain.
This happened in the case of downfall of Enron Company in United States. After the fiasco of Enron which resulted in huge losses to the investors, Sarbanes-Oxley act was enacted in order to prevent investors. But sometimes the asymmetric information threatens the job of the agent since the principal doesn’t know whether the unfavorable event was due to the agent or was the impact of the environment.
For Example: The shareholders of a company hires a CEO to take decisions for their company.The CEO may choose not to take the risky projects which might result in job losses or decrease the net profits of the company. But the shareholders might want him to even take up the risky projects which have good potential to payout. Hence the principal agent problem arises where the CEO (agent) is not working in the best interest of the principal (shareholders).