What is the principal-agent problem as it relates to corporate managers and stockholders? How did firms try to

Question

solve this problem in the 1990s? In what way did the “solution” backfire on some firms?

Answer 1

the stockholders are the principals
the managers are the agents of the principals, ie the managers work for the stockholders, and should therefore act in the best interest of the stockholders.

The principal-agent problem occurs when the agents (managers) do not act in the best interest of the stockholder (principals), but rather in their won interest. This occurs primarily because in large corporations there are many hundreds or even thousands of stockholders (owners), who do not have a real voice in how the company is run. In theory the board of directors looks out for the best interest of the stockholders and makes sure that the manages do not take advantage of their powerful positions in the company. However in practicality many of the members of boards of directors are also managers themselves, therfore the wolf is often left guarding the henhouse. The solution to this problem was to compensate managers with stock. the theory was that by rewarding managers with stock and making them stockholders, the managers would act in their own interest as stockholders and not just managers, and therfore work to maximize shareholder wealth. This however backfired in the late 90s as can clearly be seen in the Enron and Worldcom scanadal, which saw managers sell off their shares even as they at the same time acted as managers and told stockholdes that everything was going just fine.
There is no real solution to this problem. Accountability is going to remain a major problem as long as ownership is continued to be diluted. One possitve thing that came out of the scandals like Enron was the resurgence in stockholder participation in corporate governance. Many institutional stockholders such as insurance companies have incrasingly demanded decision possitions, even going so far as getting their own seats on the board of directors to better manage and oversee corporations in which they have large investments.

Answer 2

Here goes. This is really long but your question is big...

The principal-agent problem is a problem in information economics, specifically dealing with the issue of asymmetric information leading to a situation of moral hazard. Briefly, the principal-agent problem can be thought of as the following:

There is a single firm. There are two economic agents: an owner (principal) and a manager (the principal's agent). The manager takes an action in a risky environment which causes profits to be higher or lower. All other things equal, more action by the manager results in higher profits. However, the owner cannot directly observe the manager's actions and can only see profits (after the fact). Additionally, the manager values leisure and so must be provided an incentive to take on more action (do more work). The question basically comes down to "what is the right incentive?"

Because the owner cannot directly observe the manager's actions, the situation is one of "asymmetric information" - in this case, the manager knows his own action but the owner does not.

The challenge for the owner is to write a contract which is enforceable only based on his information but that provides the right incentive for the manager to work "optimally" (for the owner).

Put into a real-life situation, this can roughly be translated into the following:

Shareholders of a firm want to provide an incentive for the CEO of the firm to take the right actions and risks to generate maximum return for the shareholders. The shareholders cannot directly observe these actions but they can observe the profits the company makes (say, each quarter).

Now, imagine you are the owner:

(a) Would you give a straight salary and expect the manager to work hard? A economically rational manager would not because (s)he gets the same compensation regardless AND values leisure so (s)he would work as little as possible.

(b) Would you give a compensation which is SOLELY based on the profits of the firm? (e.g., solely profit-sharing or stock grants) The manager would not accept this because there is external risk involved. In other words, no matter how hard the manager works, the firm's profits might be zero anyway (maybe demand goes down, etc) and the manager is left with nothing.

In idealized cases, the "correct" incentive package is a combination of cash, salary, etc along with profit-based incentives such as stock grants or options.

This concludes the discussion of the abstract principal-agent problem. Now, to answer the 2nd part of your question:

The idealized principal-agent problem I've discussed above applies, in general, to a one-shot game. This means that there is only one period. Before this period begins, the owner provides the incentive contract. During the period, the managers takes his/her action. After the period, the profits are tabulated and all payouts are disbursed.

In a more complicated, repeated, game that is less stylized, there are far more intricacies. This is what happened with many of the corporate "problems" in the late 90s/early 00s. In many of these cases, the managers of the firms were able to drive the stock price of the firm up without being observed by the stockholders, sell it, then run (I'm being a bit short about this :D). To apply the above explanation to this problem, managers would have to be barred from selling their stock in intermediate periods and instead wait for the firm to be liquidated and all cash to be disbursed.

Other underlying problems with these corporate scandals were the following:

a) Complicated accounting rules and records which mitigated monitoring by shareholders even after legal reporting rules were met. In other words, much of the problems encountered were in the financial statements, but these were often too complicated to read/understand the intricacies of.

b) Trading rules which allowed managers to sell off stock long before this information was required to be disclosed, providing no additional information to shareholders.

c) In a *few* cases (though not very prevalent), the existence of a single Chair/CEO allowed this individual to set the agenda for board meetings and draw attention away from any unscrupulous practices.

This is a complicated subject. Truthfully, academics don't know how to model these situations well largely because there are too many environmental conditions to be applied. Additionally, further decentralization of the shareholder base seems to erode the sense in people that when they invest in a company, they are investing in a COMPANY not "stock". This is a basic philosophy that people such as Warren Buffett have followed but, frankly, this attitude should be the default NOT what people think. In other words, if you invest in a company you are a part owner - act like one.

Answer 3

Employees of the corp can purchase shares of stock, and then, they are the stockholders and share in the profits. Which is the only *real* way for the workers to control the means of production, as opposed to the fraudulent method created by Marx.

Answer 4

Agency Problem In Corporations

Answer 5

There was no separation because the managers were stockholders....

It backfired because managers would try to stimulate stock price.