How Ownership and Control Problems Should Be Overcome in Particular Firms - Essay Example

Principal-Agent Theory provides Definitive Answers to How Ownership and Control Problems should be overcome in Particular Firms Number Course Name and Number Name of Professor Date of Submission Number of Words: 1,062 Introduction According to Spremann (1987, pp. 5 – 7), principal-agent theory is defined as “an economic theory of cooperation with respect to the utilization of scarce resources in a world where externalities and imperfect information prevails”. In relation to the definition as provided by Spremann (1987), the principal-agent theoretical framework is useful in terms of enabling us to gain better understanding on how large-scale companies are able to effectively solve business-related problems particularly with regards to managing employees, investors and shareholders of a company. As a result of globalization, managing business is considered as a complex situation wherein the business owners should continuously develop strategic ways that can enable the company survive the internal and external business challenges. In relation to the use of principal-agent theory, this study will provide some strategic ways on how ownership and control problems should be overcome. As part of going through the main discussion, some real-life case situations will be analyzed using the principal-agent theory framework. Discussion In relation to the principal-agent framework, the agent is pertaining to the person who is offering a product or service whereas the principal is the one who pays a certain amount of money in exchange for a product or service. In line with this, the concept of principal-agent theory can also be applied in the case of a landlord (agent) and the tenant (principal) who pays rent and electricity as stipulated in the agreement contract between the landlord and the tenant (Rasmusen 2007, p. 187). The principal and the agent may or may not have complete information with regards to the future development of their business relationship. As explained by Rasmusen (2007, p. 179), the presence of moral hazard which is normally hidden by nature is a common cause of misunderstanding between the principal and the agent. In line with this, a common principal-agent problem that may arise between the landlord and the tenant is the payment for unsettled rent, electricity bills and damages that may occur inside the house. Depending on the preferred mode of payment as demanded by the landlord, the landlord can prevent the risk wherein the tenant could fail to pay the due amount of rent, damages and electricity bills by obliging the tenant to pay the amount of two months deposit plus the monthly rental fees. On the part of the tenant who is paying for the rent, the principal is more likely to demand for good quality house that is free from termites, non-functioning thermostat control, and electrical failure among others. A contract serves as a binding agreement between the principal and the agent (Jager 2008, p. 10). To avoid future contingencies and possible conflict between the landlord and the tenant, it is a common practice for landlords to ask the tenant to sign a contract with complete information regarding the agreed terms of payment before allowing the tenant to use the house or a piece of land. (See Chart I – Principal-Agent Agreement between the Landlord and the Tenant on page 4) Chart I – Principal-Agent Agreement between the Landlord and the Tenant The concept of principal-agent theory can also be applied within a large-scale business organization wherein internal and external conflicts could occur. In line with this, the stakeholders within a business organization are not limited to a group of employees but also the public investors and shareholders. It is common for business owners to be interested purely with regards to the profit they will earn out of running a business. In the case of employees, this group of individuals is more interested with the salary and benefits they will receive out of working for a company. Similar to employees, public investors and shareholders are interested in the money they will receive out of investing in a company. Considering the self-interests of the principal and the agent (Jager 2008, p. 2), the principal and the agent should always be regarded as two separate entities. When managing the stakeholders within a large-scale business organization, Halachmi and Boorsma (1998, p. 2) explained that a combined regulation or control within the business organization and motivation in the form of rewards and incentives can be utilized depending on the preferred outcome of the principal. Considering the case of a large-scale company that is looking for competitive employees to join the workforce, the employer is considered as the principal whereas the job applicant or employee is the agent (Rasmusen 2007, p. 182; Hirshleifer et al. 2005, p. 384). When hiring potential employees, the principal carefully studies the job credentials of the job applicant not only as stated in the resume but also the job applicant’s comprehensive ability to perform the task as needed within the business organization. As part of motivating a competitive job applicant to accept the job offer, it is the responsibility of the principal to offer competitive work incentives to entice the job applicant to join the company (Halachmi and Boorsma 1998, p. 2). It is a common part of business policy to forbid employees from passing sensitive business information to people within or outside the business organization. Despite the ability of the principal to hire competitive employees to work with the company, moral hazards such as the decision of the agent to disobey the business policy could result to future conflict between the principal and the agent. Between employers and employees, Cataldo (2003, p. 89) explained that the problem usually arises out of cross-organizational relationships. To prevent the agents from violating the business policy, the principal or the employer should make the agent be aware of the legal consequences associated with violating the business policy prior to the signing of employment contract between the two parties involved (Jager 2008, p. 8, 10). In the case of the shareholders and public investors, the same theory can be applied such that the shareholders and public investors are the principal and that the managers are the agent (Jager 2008, p. 9). Given that the principal-agent problem is related to poor debt financing and poor business performance, privatization of the company can be considered as the best solution to solve the principal-agent problem between the business owner and the shareholders and public investors (Sappington 1991). Conclusion The principal-agent theory is applicable in solving problems between two parties whose personal interests are different from one another. To avoid future conflicts, the use of contract is necessary to minimize the risk of miscommunication or misunderstanding between the principal and the agent. *** End *** References Cataldo, A. (2003). Information asymmetry: a unifying concept for financial and managerial and financial accounting. Elsevier Ltd. Halachmi, A., & Boorsma, P. (1998). Inter and intra government arrangements for productivity: an agency approach. Kluwer Academic Publishers. Hirshleifer, J., Glazer, A., Hirshleifer, D., & Hirshleifer, D. (2005). Price theory and applications: decisions, markets, and information. Cambridge University Press. Jager, C. (2008). The Principal-Agent-Theory Within the Context of Economic Sciences: Summary. Herstelung und Verlag. Rasmusen, E. (2007). Games and information: an introduction to game theory. Blackwell Publishing. Sappington, D. (1991). Incentives in principal agent relationships. Journal of Economic Perspectives , 3(2), pp. 45-66. Spremann, K. (1987). Agent and Principal. In Bamberg, G. and Spremann, K. (eds) "Agency Theory, Information and Incentives". pp. 3 - 37. Heidelberg etc: Springer, 1987. Read More