In economics, the problem of motivating one party to act on behalf of another is known as ‘the principal-agent problem’. The principal-agent problem arises when a principal compensates an agency for performing certain acts which are useful to the principal and costly to the agent, and where there are elements of the performance which are costly to observe. This is the case to some extent for all contracts which are written in a world of information asymmetry, uncertainty and risk. Here, principals do not know enough about whether (or to what extent) a contract is or has been satisfied.
The solution to this information problem – closely related to the moral hazard problem is to ensure (as far as possible) the provision of appropriate incentives so that agents act in the way principals wish them to. In terms of game theory, it involves changing the rules of the game so that the self-interested rational choices which the principle predicts the agent will make coincide with the choices the principal desires.
The principal can issue shares to his agent and can make them feel that they are also the owner of the business. Shares will give additional financial benefits by way of dividend.
This will encourage the agent to makes more profit, so that they will entitle for a larger dividend.
This is where the principal trust agent will allow him to make decisions without consulting with him. This decision making power will motive the agent and making feel as he/she is the owner of the business. The principal will, therefore, try to construct the agency relationship so that actions that are in the agent’s self-interest are also in the best interest of the principal.
Directors might, for example, be paid a part of their remuneration in the form of a profit-related bonus, to encourage them to earn a high profit for the company, which would benefit the shareholders.
One important aspect of the directors involvement is that no bribe should be paid as this will be seen as a conflict of interest. This can also be seen as high risk and may cause issues. The importance of all this is to be mindful of any wrong doings in the process. Director have a role to play and it is important that they do not abuse their positions in this process or damage their reputation with any wrong doings. It is important for them to also be honest and trustworthy as this will increase their credibility.
Adverse Selection VS. Moral Hazard
In the below section we will look at adverse selection vs Moral Hazard, we will also look at the conditions under the principal and the comparison between the agent. The below shows the differentiation between both.
- Adverse selection: Adverse selection is the condition under which the principal cannot ascertain if the agent accurately represents his ability to do the work for which he is being paid for.
- Moral hazard: It is the condition under which the principal cannot be sure if the agent has put maximum effort in doing his duties.