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The Principal-Agent Problem

1. Explain several dimensions of the shareholder-principal conflict with manager-agents known as the principal-agent problem. To mitigate agency problems between senior executives & shareholders, should the compensation committee of the board devote more to executive salary & bonus (cash compensation) or more to long-term incentives? Why? What role does each type of pay play in motivating managers?

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There are several dimensions to the shareholder-manager conflict. The challenge for the shareholders is to create an environment in which the manager has incentives to align her interests with those of shareholders. The shareholders typically create incentives for managers to act as the shareholder wants. The shareholder-manager conflict acerbates when the incentive system creates conflict of interest. One dimension of the shareholder-manager conflict is that the contract between the shareholder-manager is that of agency and the law of agency governs the contract. There is information asymmetry, uncertainty, and risk. Often the shareholders cannot say the extent to which the contract has been satisfied and they end up paying agency costs. Some shareholders have been focused on creating an employment contract that aligns their interest with that of ...

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This solution explains the Principal-Agent Problem. The sources used are also included in the solution.