The principal-agent problem arises because an agent is given the responsibility and authority to take actions that affect both the principal, but can also affect the agent. The key to the principal-agent problem is that principals and agents are people, people who seek to maximize utility. As people, they prefer more to less. To satisfy unlimited wants and needs these people take actions and make decisions that generate as much utility as possible. We can go into details and do more research on what models work or don’t work for P-A problems and or the situations which results in P-A problem, but bottom line we are dealing with humans who have needs/wants. Practices like offshoring workforce and allowing employees to work from home, the process of monitoring the agent (manager) by principal (CEO) is getting optional. So the question whether the agent is working towards the best interest of principal, if so why and if not why.
What makes the agent to work in the best interest of the principal?
• Performance Bonus
• Recognition by awarding
• Stock options
Reasons why the agent does not work in the best interest of principal:
• Conflicts of interest
• Risk averse
• Disconnect between goals/objectives
Mining industry especially precious metals (Gold, Silver etc.) is very sensitive to the metal prices and the fluctuations in metal prices in the market will result in adjusting the operating model and philosophy how we operate mines. The P-A problem can arise when the agent (manager of the mine) has different approach or method in operating the mine, basically making sure the mine makes profit (free cash flow) and also sustainable for the community stakeholders, on the contrary the principal (CEO) might have a different interest or opinion about the mine as he/she is looking at the portfolio of the organization. To solve the P-A problem we need to know what is the production process and it varies widely across industries.
Doing some research I came across some of the principal-agent problems:
1. Adverse selection problem
2. Monopolistic screening problem
3. Moral hazard problem
• If the goals/objectives of the CEO are aligned with the manager the probability of principal-agent problem can be minimized.
• Compensation, awards and recognition of effort on projects/reports are some ways to keep the manager engaged and motivated to input maximum efficiency at work.
• Most of the major firm executives have modeled their benefits and compensation towards the improvement of the share prices. The P-A conflict between manager and CEO can be avoided when the strategy map is aligned between them.
• The payment process should emphasize on stock bonuses and multi-year performances, so that long-term strategies are pursued by the management.
• Must be cautious when investing in assets which you don’t understand and don’t take things granted from your agent and perform risk analysis.