Principal Agent Problem Essay

Principal Agent Problem Running a business can be a tricky expenditure in today’s society. As we know a business can only be successful economically if they are bringing more money than they are putting out. Owners of businesses realize that positive economic profit is essential to the livelihood of their businesses. As with every business, employees are hired to do specific tasks that the owner assigns for them. However, with employees comes the responsibility of managing them. This is where a manager comes into the picture. A manager is hired so that he/she can control the operations so that the business can run smoothly and make money.

After all the main goal of any manager should always be to maximize the value of the business they are working for. However, in businesses where the owner is not in the workplace the majority of the time a problem may naturally occur over time. This problem in question is the principal agent problem. If a principal agent problem rears its head the health of the business may be put into jeopardy. To understand why the principal agent problem is such a severe issue one has to understand what it truly is and how it applies to a real life scenario.

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Principal agent problems typically occur when an owner is away from their business and has delegated full control to a manager. By delegating control an owner has given their trust to the manager. They fully expect a manager to maximize the value of their business to the upmost degree. After all maximizing the value of a business should be the number one goal of any manager. However, in cases where the owner is not around, the separation of the principal (owner) and the agent (manager) becomes evident. Supervision of the agent has become lost and personal interests may begin to take over.

An agent (manager) may begin to perform actions that the principal (owner) does not want them to do. Theory of the firm states that managers should maximize value based on the constraints given to them by resources and society. However, this cannot happen with an active principal agent problem. Therefore, a principal agent problem should be solved as quickly as possible so that the agent (manager) can go back to his role of using managerial economics to find optimal solutions for management decision problems.

To fully illustrate the principal agent problem, I will go over how this problem has affected a local restaurant in Seattle. For the purpose of this essay I will name the restaurant China North as the owner of this restaurant is a family friend and wishes to be anonymous. China North is located in the Queen Anne neighborhood and has been in business for over twenty years. Currently business here is doing fairly well but not as good as years past. Specifically, profitability has been down since the Seattle Supersonics left to Oklahoma City in 2008.

With the teams relocation the restaurant saw a decrease in customers over the time period when a typical NBA schedule is played. To make up for the loss of customers the principal (owner) expects her restaurant to run efficiently by her manager so that maximum profitability can still be attained. The principal (owner) used to be in the restaurant daily but as she has aged she now only comes in a couple days of the week during the dinner hours. Therefore, the agent (manager) she has put in charge of the restaurant has no supervision for most of the day. This is where the principal agent problem has begun to manifest.

As the principal (owner) of the restaurant fades more and more into the background the agent (manager) has started to take advantage of the resources that has been given to him. The agent (manager) has begun to give away free food and drinks to his friends and family members. While given permission to give away complimentary items in the past at a small scale, he has begun to give away items at a level that now surpasses what the principal (owner) find acceptable. These friends and family members still tip the employees of the restaurant and typically they do so in higher quantities than if they were to pay like regular patrons.

This is why the employees of the restaurant have no incentive to stop or report the agent (manager) from giving away free items. The agent (manager) essentially has taken up the teleological approach of egoism which states that person actions include, “Action consistently with one’s own (or organization’s) self-interest is ethical, with individual consequences taking priority, regardless of the consequences to others” (“Frameworks for Teaching and Learning Business Ethics” 470).

The agent (manager) is benefiting at the cost of the principal (owner) by aligning his ethical interests in places not consistent with the principal (owner). Obviously the problem here is clear to principal (owner) but the process of fixing the problem is not quite as clear. The problem lies in the fact that agent (manager) has been part of the business for years and has essentially become part of the social fabric of the restaurant. The agent (manager) started as a bus boy and worked his way up to being an agent (manager). This is why the principal (owner) does not want to outright fire the agent (manager).

With the option of a firing being a last resort issue the only way to alleviate this problem then would be for the principal (owner) to create a system of incentives that would force the agent (manager) to correct himself. There are numerous ways to solve this situation. One way to solve this situation would be to offer the agent (manager) a share into the restaurant. This process would ideally work because it would “ensure that managers themselves have an interest in the value of the shares” (Lipsey &Chrystal, “Principal agent-theory”).

By doing this it would encourage the agent (manager) to finally begin taking his responsibilities as a manager seriously. He will understand that giving away free food and free drinks negatively impacts the restaurant profits. With a share of the restaurant every time he gives away food and drinks he himself will be losing money whereas before the only person who was hurting was the principal (owner). Another theory into fixing this principal-agent problem would be to give incentive laden performance awards.

This would be basically offering bonuses when certain milestones are met. This would be a great motivator for the agent (manager) to make the most money possible for the restaurant. The idea of incentives would push the agent (manager) in a way that he has not had before. This type of deal would force him to maximize the restaurant in the biggest way possible so that he will make more money for himself. In addition to giving money for completed incentives the principal (owner) could give out penalty incentives. A penalty could be included for below profit earnings.

The idea of a penalty for not meeting minimum profit earnings agreed upon by the principal (owner) and agent (manager) should in addition also push the agent (manager) to fulfill his duties as a manager to the best of his ability. A final way to solve this principal agent problem would be to outright demote the agent (manager) in question. Since the principal (owner) does not want to fire a friend a demotion would finally push the message that what the agent (manager) in question was doing was not acceptable to the business.

In addition the demotion of a person who seemed to have so much goodwill within the restaurant would also show the rest of the employees that ignorance of the rules will result in changes. In this scenario the agent (manager) could choose to leave the restaurant after spending years there or choosing to work his way back into his managerial role once again. Overall, changes must be so that restaurant can achieve maximization of profit. It is necessary that changes are made so that efficiency once again rules here.

It is especially important for this situation to be resolved in light of news that the Seattle Supersonics may return once again. If they do in fact return it is speculated that they will play in the Key Arena for two years (Stiles). This would do wonders for the business as Queen Anne businesses always flourish during the NBA season. With the principle agent problem resolved the restaurant can achieve high levels of profitability for the next two years and maintain a good business model even after the team was to move to their new arena in the SODO area.

The principal agent problem is a big one but it can be solved if both parties are willing to work together. When this happens the agent and the principal will have finally aligned their interests and put the business in the best position to succeed. Works Cited ‘Frameworks for Teaching and Learning Business Ethics’. Journal of Management Education. Aug 2004. Vol 28, Issue 4 “Lipsey & Chrystal: Economics 11e. ” Principal-agent Theory. N. p. , n. d. Web. 26 Jan. 2013. “The Principle Agent Problem. ” Tutor2u. N. p. , n. d. Web. 26 Jan. 2013. Dubner, S. (2012, September 11). Tax tipping and the principle agent problem-