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For example, a landlord may be reluctant to lend if he fears that a tenant may mistreat his property and be unable to know how it is cared for. Principals may be reluctant to enter into a contract at all for the fear that they will not know what is going on. Due to information asymmetries, principals may be unaware of how much a contract has been fulfilled. Costs of Principal-Agent ProblemĪgency costs. This has led to major banking collapses, such as rogue trader Nick Leeson and Barings Bank (1995). If he fails and loses $700m, the losses are absorbed by the bank (or taxpayer) – not by the individual banker. This encourages the banker to take risky investments. This is an example of moral hazard.įor example, an investment banker may gain a bonus for making high profits. The principal-agent problem can also lead to an individual taking an excessive risk because the ultimate cost is borne by someone else. They will gain $500 whatever happens to the grade. The lazy student pays $500 for the essay, but the person writing the essay in anonymity has not the same motivation and may not care about the quality. Apart from being cheating which could lead the student to be expelled, it is also an example of a principal-agent problem. Suppose a lazy student paid a random stranger on the internet to write a dissertation.
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AGENT OF THE PRINCIPAL DEFINITION WINDOWS
But, tenants may open windows rather than turn down the heating. He asks tenants to take care of the property and minimise electricity bills.
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The landlord owns house and rents out to tenants. Instead, they concentrate on enjoying work and getting on with workers. However, the manager and workers, who are responsible for day to day running of the firm, may fail to pursue profit maximisation. Shareholders will wish to maximise a firm’s profits to increase their dividends.
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The principal-agent problem can lead to market failure because the agent pursues his own self-interest rather than that of the principal and the business may be run in an inefficient way. Also, in this situation, the manager does not share the same interest in maximising profits as the owner. However, due to agency costs, the shareholder cannot fully know how hard the agent is working and to what extent the manager is fulfilling the contract. He hires a manager (agent) to run the business. Secondly, the interests of the principal diverge from that of the agent, meaning that the outcome is less desirable than the principal expects.įor example, a shareholder (principal) wants to maximise profits for his firm.
AGENT OF THE PRINCIPAL DEFINITION FULL
The principal-agent problem occurs when a principal delegates an action to another individual (agent), but the principal does not have full information about how the agent will behave.