Microeconomics 008: The Agency Problem

Producer Behaviour in Reality

The behaviour of producers do not align with economic theories. For example, we see company making huge losses but the CEO still receive a pay raise. This can be explained with two main reasons:

  1. The CEOs are really talented and are truly worth the amount of compensation, despite the performance of the company.
  2. The agency problem.

The Agency Problem

In a sole proprietorship, the owner of the company also controls the production. Therefore, it is more likely that the company is profit maximising, for the benefit of the owner. However, in a corporation, the ownership of the company and the control over production is separated, between equity holders and employed managers. Since the managers do not own the company, they may have their own agenda that deviates from profit maximisation.

This is a problem of imperfect information. Owners do not have information that the managers do pertaining to production, hence they are unable to know if the right decisions had been made. To bridge the gap between owners and managers, the board of directors exist to monitor the managers for the interest of the owners. Even with the board, it is still hard to gain information of the production. Moreover, the board is often appointed by the managers, hence instating the board does not solve the problem.

Aligning Owners and Managers

A popular solution was to make the managers have a stake in the company, by providing stocks or stock options.

  • Stocks provide the managers with a direct stake in the company
  • Stock options provide the managers with an option to purchase the stocks of the company at a fixed price, regardless of the market price of the stock when the managers effect the purchase

This solution was effective and popular until the last decade, when the unintended consequences of this scheme start to surface:

  1. Excessive risk taking – for managers who are offered stock options, they would take excessive risks for the stock price of the company to rise, beyond what would normally be taken by the owner of the company. This is because stock options allow managers to gain upside and bear no downside losses.
  2. Cheating – unfortunately, the managers are the ones to decide the compensation structures, which resulted in ugly practices like backdated stock options.

(Reference: MIT OCW Principles of Microeconomics)

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