Perceived managerial discretion and market competition (Principal-agent problem) - Research Paper Example

?Introduction The principal-agent problem arises from the conflict of interest between the principal as represented by the shareholders and the agentas represented by the officers. The shareholders represent the owners of the organization and they want to maximize the wealth of the organization by investing in high-risk projects which offer high returns. However the officers may be reluctant to invest in the high-risk projects because this might put their job security in question. For this reason there is a conflict of interest which leads to the principal-agent problem. A review of the principal-agent problem is useful in terms of creating an organizational structure which synergizes principal’s interest with the agent’s interest. This organizational structure optimizes the decision-making process to the benefit of both the principal and the agent. As a result the organizational performance is maximized. By analyzing the principal-agent problem, the shareholders and the officers are able to coordinate their efforts to the best advantage. The agency theory According to the agency theory, the principal-agent problem arises from conditions of incomplete or asymmetric information when one party tries to motivate another party to act on its behalf. These conditions can be observed in any employer/employee relationship. This is because the employer, the shareholders, wants the employees, the managers, to invest in those projects which offer higher returns. However the projects which offer higher returns also have higher uncertainty. Therefore the managers may not want to take the risk. As a result there is a conflict of interest which affects organizational objectives. This is the principal-agent problem which is addressed in the agency theory. In order to maximize organizational performance, the owners of the organization have to introduce incentives which will motivate the managers/employees to act in the best interests of the shareholders. Therefore the motivations of the principal and its agent are aligned strategically. In the current business environment, change is the only constant. Therefore the organizational structure has to be flexible so that the organization can remain competitive in spite of the changes that are taking place in the external environment. A flexible organizational structure enables the principal and the agent to mobilize resources fast so that fast responses to market changes become possible. However if there is a conflict of interest between the two parties, then this objective cannot be attainable. The presence of the principal-agent problem also means that the shareholders are unable to monitor the decision-making process so that the managers are tempted to apply organizational resources to personal gains. This is a limiting factor for organizational performance. Therefore it is critical to address the principal-agent problem. Particularly in the present day business environment which is characterized by high competition, application of the agency theory becomes one of the key success factors. By incorporating the agency theory, organizational stakeholders create an internal structure which is strategically aligned. Given the fast pace of change in the external environment, both the shareholders and the officers would want to create a sustainable competitive advantage. In order to meet this objective, the management of the company has to optimize the decision making process so that it addresses the interests of both parties. According to Michael Porter’s framework for strategy formulation, an organization can implement three strategies to build a competitive position: focus, differentiation and cost minimization (Hill & Jones, 2007, p. 18). However the effectiveness of strategy implementation is limited by the principal-agent problem. This underscores understanding of the agency theory. By applying the agency theory, the management can align the interests of both parties to synergistic effects. As a result, the organization can implement competitive strategies to the maximum effect. Because the external environment is constantly changing in terms of managerial and technological development, reducing the conflict of interest as defined in the agency theory is one of the key success factors. From the above it can be seen that the principal-agent problem determines organizational success to a considerable extent. Therefore it is important to see what strategies are available to the management in addressing the problem. As mentioned before, the principal-agent problem arises from the different interests of the parties involved. The principal is interested in wealth maximization. The agent is interested in job security. Therefore the management needs to undertake those strategies which will address both interests to the common organizational good. In this respect the introduction of incentives meets the objective. One of the incentives can be share options giving employees the privilege to purchase company shares. As a result the employees will be motivated to undertake those strategies which maximize company profitability so that share prices will be maximized. The result is wealth maximization which is the main interest of the shareholders. Therefore, in order to address the principal-agent problem, the management should introduce incentives such as share options. Given the high competition in the external environment, the management needs to undertake those strategies which will create a sustainable competitive advantage for the organization. However, as mentioned before, the success in implementing these strategies depends upon addressing the principal- agent problem. The problem occurs because the interests of the principal diverge from those of the agent. This makes the question of monitoring relevant. However the shareholders who represent the principals may not be able to monitor all the actions of the officers who represent the agents. Monitoring can also have a negative effect on employee motivation. In this situation, the only alternative is to offer incentives such as share options to the employees so that they are motivated to maximize their performance in a manner which is strategically aligned. Given the fast change occurring in the external environment, one of the key success factors is to create a motivated workforce in which the agency theory plays an important role. In addition to share options, the management can also tie remuneration of the agents to company profit. As a result the officers working in the company will be motivated to undertake those strategies which create a sustainable competitive advantage for the organization. Whether the competitive advantage is sustainable depends upon the market conditions. In creating a competitive advantage, the organization can implement the strategies of cost, differentiation and focus. However these strategies are also available to the competitor organizations and therefore any competitive advantage resulting from the implementation of these strategies can face obsolescence very quickly. However, if the competitive advantage is rooted in the organizational culture, then it becomes sustainable because each organizational culture is unique (Evans, 2004, p. 56). It is defined as the set of values and behaviors which contribute to the social and psychological environment within the organization. The principal-agent problem can be limiting factor on the organizational culture’s strategic value. Therefore addressing this problem is of paramount importance. The top management can address the agency theory by introducing incentives such as share options or tying remuneration to company profits. A third option to address the principal-agent problem is to tie promotion to company profit. Those employees whose actions increase company profitability will be promoted faster. This will motivate employees to increase their skills levels so that they are able to contribute to company profitability to a greater extent. In the process company profitability is maximized. In addressing the principal-agent problem, the top management implements this strategy which results in a work force which maintains the latest skills levels. This is also related to the organizational culture. Therefore, implementing the agency theory can lead to human capital which can be the source of a sustainable competitive advantage. The most important asset for an organization is its human resources. By addressing the principal-agent problem, the management can create human capital. The organization needs to develop a competitive advantage that can be sustained in the face of rapid change in the market environment. This sustainability can be achieved by implementing HR practices. HR practices enable an organization to create an organizational culture which ties employee satisfaction to the strategic focus. This addresses the principal-agent problem in terms of motivating employees to act in the best interests of the shareholders. Three types of incentives can be used to resolve the conflict of interest between the principal and the agent. One is to offer share options to the employees. The second is to tie their remuneration to the company bottom line. A third incentive can be to tie promotion to company profitability. Making these incentives a part of the organizational structure is possible through HR practices. Therefore, in addressing the principal-agent problem, the top management will have to implement HR practices. The implementation of HR practices institutionalizes the development of human capital since the main objective of HR practices is to ensure employee satisfaction. Given that employees are the most important assets of an organization, it is imperative for the top management to create a working environment which meets this objective. The management may not be in a position to meet this objective if the principal-agent problem persists. As mentioned before, the top management can invest in HR practices in order to address this problem. How much importance the top management places upon human resource management depends upon its link to the strategic focus of the organization. As mentioned before, the effectiveness of the strategic focus is limited by the principal-agent problem. For this reason, consideration of the agency theory leads to the implementation of HR practices. In considering the principal-agent problem, the management’s attention is drawn to the need for developing human capital by implementing HR functions. This indicates the wide-ranging impact that the agency theory can have. The agency theory drives issues that are related to organizational culture, the source of an organization’s competitive advantage. In considering the principal-agent problem, it is necessary to look into the concept of core competencies. Core competencies are defined as those factors which create a sustainable competitive advantage for the organization. However, given the fast change that is occurring in the external environment, the core competencies have to be continuously improved so that the competitive advantage remains relevant. Since managers are in direct contact with the market conditions, they should be given a considerable level of decision making authority in strategy formulation. The extent of decision making authority to be granted to the managers creates the principal-agent problem. The managers might be tempted to abuse the privilege by using company resources for personal benefits. However, if the external environment is characterized by a high level of competitiveness, then shareholders must decentralize the decision making process and address the implications of the agency theory. Given the importance of the organizational culture in creating a sustainable competitive advantage, the top management must address the principal-agent problem so that the organizational culture is aligned to the strategic focus of the company. As long as the principal-agent problem persists, this strategic alignment is not attainable. The use of incentives to resolve the conflict of interest has been discussed. The management will have to implement HR practices in order to institutionalize these incentives. It is not possible for the principal to monitor all the actions by the agent because the principal does not possess the expertise. For this reason, transfer of decision making authority from the principal to the agent is essential. By using such incentives as share options, the principal can ensure that the agent’s actions are aligned to the strategic focus of the company. The greater the competitiveness of the external environment, the stronger is the case for managerial discretion in determining organizational outcomes. Bibliography Zhao, X., Chu, P., & Chen, C. (2010). Perceived managerial discretion and firm performance: the moderating role of market competition. Social Behavior and Personality, 38(2), 145-158. Retrieved from https://web.ebscohost.com/ehost/pdfviewer/pdfviewer? vid=4&hid=126&sid=f6d93303-a6c6-470c-8e4e-5405d901b181%40sessionmgr110. In the article, the authors have emphasized upon the link between managerial discretion and firm performance. In other words, to improve firm performance, the managers must be given decision making authority. This leads to a decentralized organizational structure. In a decentralized organizational structure, it is not possible for the management to monitor the actions of the agents. Managerial discretion means that managers have the authority to act as they see fit. As the authors state, this is particularly so in a highly competitive environment. Because competitive environments are changing all the time, the organizational structure has to be dynamic. This objective can only be met by creating an organizational culture based upon managerial discretion. In the article, Zhao, Chu and Chen (2010) have defined managerial discretion as the ability of executives to affect key organizational outcomes. Therefore the occurrence of managerial discretion has implications for the agency theory. A high level of managerial discretion means that managers might take decisions which serve their own interests rather than those of the shareholders. However in competitive environments, shareholders have to create an organizational structure which permits a high degree of managerial discretion. The importance of creating a sustainable competitive advantage has been emphasized upon. In a highly competitive environment, a competitive advantage cannot be sustainable unless the organization has the ability to change fast in response to changing conditions in the external environment. For this reason there are strong grounds for creating a dynamic organizational structure which necessitates the issues of managerial discretion which has repercussions on the agency theory. The authors of the article have mentioned the difference between managerial discretion and perceived managerial discretion. The authors have stated that unless managers have the right perception about how much decision-making authority they have, they will not be in a position to take the right decisions and the principal-agent problem will arise. Given the repercussions that managerial discretion has on the agency theory, the best situation is one in which there is little or no managerial discretion. However, there has to be some decentralization of the decision making process in competitive environments. If all the decisions rest with the top management, then the process will be complicated and strategy implementation will fall behind. As a result the organization loses its competitive advantage. Creating a sustainable competitive advantage necessitates managerial discretion. However this means that the managers might work for personal benefits rather than for the shareholders. The authors in the article have stated that there is a strong link between the need for managerial discretion and the competitiveness of the external environment. When discussing the implications of managerial discretion, the principal-agent problem becomes relevant. Given that the present business environment is highly competitive in nature, characterized by a fast pace of change, then the implications of managerial discretion must be looked into when analyzing the principal-agent problem. That is why this article has been chosen in furthering the analysis of the principal-agent problem. The management of an organization has to implement strategies to counter the high competitive threat in the external environment as defined in Porter’s five forces analysis. The best competitive strategies are implemented when there is a high degree of managerial discretion. However this flexibility creates the principal-agent problem. I agree with the authors that if the managers have high decision-making authority, then it creates the principal-agent problem. I also agree about the importance of perceived managerial discretion. If the managers perceive their decision making authority to be low when actually it is high, then they will not undertake new strategic initiatives even if they have the authority to do so. If they perceive their decision making authority to be high when in reality it is not, then they will waste resources in strategies which may not be implemented. Therefore the managers should have the right perception about how much managerial discretion they have. But then again the top management has to consider the principal-agent problem when granting a high level of managerial discretion to the managers. I agree that the competitiveness of the external environment should determine to what extent managerial discretion is required by the organization. If there is a fast pace of change in the external environment driven by competition, then the managers should have the authority to make their own decisions and determine the strategic direction accordingly. I disagree about managerial discretion leading to the principal-agent problem in all cases since the introduction of incentives can have a moderating influence on the extent of the problem. Even in the organizational structure which has a high degree of managerial discretion, the introduction of incentives such as share options can ensure that the manager’s decisions serve the shareholders’ interests rather than their own. I agree that the degree of competitiveness in the external environment should determine the extent to which managerial discretion should be given to the managers. But it does not mean that the effectiveness of this organizational structure is limited by the principal-agent problem. The top management can introduce incentives which will motivate managers to use managerial freedom in the interests of maximizing firm performance rather than in the interests of personal objectives. In this manner, the agency theory is linked to the competitive threat. By addressing the agency theory, the management can create a sustainable competitive advantage. I agree about the role of perception in the success of managerial discretion. In this respect the management might have to arrange training and development programs in order to enable the managers to perceive how much control they have in determining organizational outcomes. In this manner strategic alignment may be achieved. If the managers do not have the right perception, this will have a negative effect on their motivation. In that case the introduction of incentives will not resolve the conflict of interest between the shareholders and the managers. Because the managers do not have the right perception about how much authority they have in decision making, they are not in a position to make the connection between their work and the strategic focus of the company. As a result, addressing the principal-agent problem is not effective. It is only when the managers have the right perception about how much managerial discretion they have, that the top management has to address the principal-agent problem. Then the management has to introduce incentives in order to ensure that managerial freedom has the desired outcomes. According to the article, managerial discretion is a key determinant of organizational performance. This means that if the managers are given wide latitude in making decisions then such a structure might have both a negative and a positive impact on corporate performance. The managers might decide to pursue personal objectives, in which case corporate performance is compromised. However such a possibility is limited when the management introduces incentives. As mentioned before, one of the incentives is to tie promotion to company profit. As a result, if the managers pursue personal objectives, then they will not get promoted. Such incentives make the decision making process effective with a high degree of managerial discretion. Depending upon the competitive threat in the external environment, managerial discretion is a key determinant of corporate performance. The result is the principal-agent problem. Therefore decision-making discretion is feasible to arrange only when the principal-agent problem has been addressed. According to the article, the extent to which managerial freedom in decision-making affects organizational outcomes depends upon the competitive threat in the external environment. If the environment is not intensely competitive, then high discretion in decision making is not likely to lead to strategic effects. In this scenario, the managers have less control in determining organizational outcomes. However the present business environment is characterized by a high competitive threat. The competition is driven by both technological and managerial developments. Therefore organizations in the present day business environment have to maintain flexible, dynamic organizational structures. As a result managerial discretion becomes a key success factor. Only when the managers have high discretion in decision making is it possible to maximize the flexibility in strategic directions. However, as mentioned before, high discretion creates the principal-agent problem. But high competitiveness in the external environment is unavoidable in the present day business environment. Therefore the agency theory has an essential role in operations. Zhao, Chu and Chen (2010) have taken the existing research on managerial discretion further to include the concept of perception. According to the research findings presented in the article, good perception has a positive influence on organizational performance in highly competitive markets. Competition means that there are frequent market changes. The organization has to react fast and managerial discretion becomes essential. In that case the managers must be trained to perceive the extent to which they have decision making authority. Then the management has to ensure that the principal-agent problem is addressed. According to the article, the principal-agent problem arises when managers have decision-making latitude. Given the fit between managerial discretion and competition as presented in the article, the principal-agent problem is more relevant in competitive markets since in these markets the board of directors has to authorize decision-making discretion to the firm’s manager. As a result the principal-agent problem becomes relevant. Conclusion Principal-agent problem represents the conflict of interest between the principal and the agent. The principal is represented by the shareholders and the agent by the officers. The agency theory incorporates the principal-agent problem. It is an important consideration because unless the officers’ interests are aligned to shareholder’s interests, corporate performance will suffer. In order to resolve the conflict of interest, organizations might introduce different incentives such as share options. These incentives motivate the managers to act in a manner which serves both their interests and those of the shareholders. As a result firm performance is maximized. Addressing the principal-agent problem is directly related to maximizing firm performance. Therefore addressing this problem is one of the key success factors. In the present day business environment, an organization needs to create a sustainable competitive advantage. This objective can be met by creating human capital which also concerns the agency theory. The article has been chosen because its topic, perceived managerial discretion, directly concerns the principal-agent problem. The authors state that that the fit between perceived managerial discretion and market competition would impact upon corporate performance. However all these factors have direct implications for the principal-agent problem since it involves aligning the interests of managerial freedom to shareholder’s interests. By introducing incentives such as share options, the board of directors can ensure that managerial freedom is strategically aligned to shareholder’s interests. In an intensely competitive environment, perceived managerial discretion is a key success factor and to make it work, organizations have to address the principal-agent problem. By addressing the principal-agent problem, organizations can build a sustainable competitive advantage. References Evans, J. R. (2004). Total quality: management, organization, strategy. New York: McGraw Hill/Irwin. Hill, C., & Jones, G. (2007). Strategic management theory: an integrated approach. New York: McGraw Hill/Irwin. Zhao, X., Chu, P., & Chen, C. (2010). Perceived managerial discretion and firm performance: the moderating role of market competition. Social Behavior and Personality, 38(2), 145-158. Retrieved from https://web.ebscohost.com/ehost/pdfviewer/pdfviewer? vid=4&hid=126&sid=f6d93303-a6c6-470c-8e4e-5405d901b181%40sessionmgr110. Read More