The Principal-Agent ProblemThe Principal-Agent Problem

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

• ““Negligence and profusion … must always Negligence and profusion … must always prevail in such a company.”prevail in such a company.”

The Principal-Agent ProblemThe Principal-Agent Problem

• The bulk of the dividends go to outside The bulk of the dividends go to outside shareholders.shareholders.

• All the major decisions are taken by the All the major decisions are taken by the corporate officers.corporate officers.

• The outside shareholders are unable to The outside shareholders are unable to control the corporate officers.control the corporate officers.

• The interests of the shareholders and the The interests of the shareholders and the corporate officers diverge significantly.corporate officers diverge significantly.

The Principal-Agent ProblemThe Principal-Agent Problem

• Shareholders: PROFITShareholders: PROFIT

• Corporate Officers: POWER, PRESTIGE, Corporate Officers: POWER, PRESTIGE, PERSONAL WEALTHPERSONAL WEALTH

• Senior managers may be in a position to Senior managers may be in a position to enrich themselves at the expense of the enrich themselves at the expense of the shareholders.shareholders.

£

QO

TC

TR

Q2 Q1Q3

Total profit

Sales revenue maximising with a profit constraintSales revenue maximising with a profit constraint

ALTERNATIVE MAXIMISING THEORIESALTERNATIVE 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

• 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

ALTERNATIVE MAXIMISING THEORIESALTERNATIVE 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

• 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

Agency TheoryAgency Theory

• Agency theory in its simplest form Agency theory in its simplest form discusses the relationship between two (or discusses the relationship between two (or more) people, a principal and an agent who more) people, a principal and an agent who makes decisions on behalf of the principal.makes decisions on behalf of the principal.

• Owners of firms and their managers.Owners of firms and their managers.

• Patient-doctor.Patient-doctor.

• Managers and their subordinates.Managers and their subordinates.

Agency TheoryAgency Theory

• All agency relationships involve moral All agency relationships involve moral hazard.hazard.

• ““the principal and the agent may have the principal and the agent may have different objectives and the principal different objectives and the principal cannot easily determine whether the cannot easily determine whether the agent’s reports and actions are being taken agent’s reports and actions are being taken in pursuit of the principal’s goals or self-in pursuit of the principal’s goals or self-interested behaviour.” interested behaviour.”

Agency TheoryAgency Theory

• Informational AsymmetryInformational Asymmetry

• Monitoring Monitoring

• The Free Rider ProblemThe Free Rider Problem

External Constraints on ManagersExternal Constraints on Managers

• The Product MarketThe Product Market

• The Market for Corporate ControlThe Market for Corporate Control

• The Market for Managerial LabourThe Market for Managerial Labour

Internal Control MechanismsInternal Control Mechanisms

• Performance Related PayPerformance Related Pay

– concentrates the risk of agentsconcentrates the risk of agents– promotes short term profitpromotes short term profit– share options schemes are asymmetricshare options schemes are asymmetric

– compensation committeescompensation committees

– size does mattersize does matter

Additional Control MechanismsAdditional Control Mechanisms

• The Board of DirectorsThe Board of Directors

• Multiple Principals - the Role of the BanksMultiple Principals - the Role of the Banks

• Managerial Bonding: the Role of DebtManagerial Bonding: the Role of Debt