Managerial theories and the principal agent problem: The conflict between managers’ and shareholders’ objectives.
According to Sloman (2006) the principal-agent problem occurs where people, as a result of lack of knowledge; cannot ensure that their best interests are served by their agents. Agents, according to Sloman (2006); may take advantage of this situation to the disadvantage of the principals. The principal-agent problem also refers to the conflicts of interest and moral hard issues that arise when a principal hires an agent to perform specific duties that are in the best interest of the principal.
Basically, this conflict emanates when shareholders (principals) contract a second party, the managers (agents) to perform some tasks on their behalf. The dilemma exists and is arguably inevitable because in most instances the agent is motivated to act his or her own best interests rather than those of the principal. The main reason for that is that the agent knows that they have some hidden information that puts them on a better position to engage in moral hazard. This is theoretically justified because the shareholders cannot possess all the information because of bounded rationality. Bounded rationality simply means that individuals cannot solve problems perfectly, costlessly and instantaneously.
Therefore, managers take advantage of the knowledge that they have only to pursue their personal agenda at the expense of their shareholders objectives. The principal-agent problem often arises when two parties have diverging objectives and asymmetric information (or simply hidden information) such that the shareholders cannot directly be certain that the decision made by manager is to their best interest because the manager would always be better informed than the shareholders, thereby automatically initiating conflict between the shareholders and managers.
The objectives of the manager and those of the shareholders may initially not be in conflict but by the time managers try to achieve the set objectives, shareholders will not be there to keep a close eye on the actions of the managers. On such grounds, it gives room for the manager to divert organisational goals to their own agenda. It is however, important to note that some economists such as Wilkinson (2005) have recommended monitoring as one of the possible remedies to the principal agent problem. However, monitoring in its own right also results in the principal agent problem because the third party employed to monitor the agent is also an agent! So, this is how the principal agent problem is a simple and yet unique problem in managerial economics; especially when it comes to solving it. The conflict between managers and shareholders may arise on whether to maximise profits in the short run or long run. The neoclassical model posits that maximisation of profit in the short run would alert other competitors to enter the market since they would be aware of the high profits due to the difference between prices and costs, and because of that; shareholders might want to maximise profits in the long run through market share dominance and price leadership.