Divorce of ownership from control: the principal-agent problem

Divorce of ownership from control

In a public limited company, thousands of shareholders own the firm but appoint directors and managers to run it. Ownership and control are separated. Shareholders usually want maximum profit and dividends; managers may want high pay, status, a larger firm, job security or an easier life.

The principal-agent problem

A principal (the shareholder) hires an agent (the manager) to act on their behalf. The problem arises because:

• their objectives differ, and
• there is asymmetric information: managers know far more about the firm than shareholders and are hard to monitor.

So managers may pursue revenue or sales maximisation, or satisfice, rather than maximise profit. The same idea applies to governments (principal) and SOE managers (agent), or to employers and workers.

Reducing the problem

• Link pay to performance: profit-related bonuses, share options.
• Non-executive directors and independent audit to monitor managers.
• Shareholder votes on pay; active institutional shareholders.
• The threat of takeover: a poorly run firm has a low share price and may be bought by a firm that will replace the managers.

Each solution has limits: share options can encourage short-termism, and monitoring is costly.

Worked example

A chief executive's bonus depends on the firm's sales revenue. Explain how this could create a principal-agent problem.

1. Shareholders (principals) want maximum profit.
2. The manager (agent) is rewarded for revenue, so may cut prices and expand output to where MR = 0.
3. This output is beyond MC = MR, so profit is lower than shareholders would choose.

Answer: Revenue-linked pay pushes the agent towards revenue maximisation, against the principals' profit goal.

Check yourself

1. In the principal-agent problem in a public limited company, the principal is
   • the managers
   • the shareholders
   • the customers
   • the suppliers
   Show answer

   the shareholders. Shareholders own the firm and appoint managers to act for them.

2. Which two conditions create a principal-agent problem?
   • Perfect information and the same objectives
   • High barriers to entry and patents
   • Low wages and high taxes
   • Different objectives and asymmetric information
   Show answer

   Different objectives and asymmetric information. If goals differed but owners could see everything, they could enforce their goals; if goals matched there would be no conflict.

3. Which measure is designed to align managers' objectives with those of shareholders?
   • Paying managers a fixed salary regardless of results
   • Paying managers partly in shares or share options
   • Giving managers longer holidays
   • Increasing the number of shareholders
   Show answer

   Paying managers partly in shares or share options. If managers own shares, they gain when profit and the share price rise.

4. How does the threat of a takeover reduce the principal-agent problem?
   • Takeovers always raise managers' pay
   • Takeovers stop shareholders voting
   • Poorly managed firms have low share prices and may be bought, and their managers replaced
   • It forces firms to become co-operatives
   Show answer

   Poorly managed firms have low share prices and may be bought, and their managers replaced. Managers who neglect profit risk losing their jobs.

5. A manager who aims for a satisfactory profit while expanding the firm to raise their own status is
   • satisficing
   • profit maximising
   • a principal
   • practising price discrimination
   Show answer

   satisficing. Satisficing means aiming for 'enough' profit rather than the maximum.

6. Explain why asymmetric information matters in the principal-agent problem.
   Show answer

   Managers know much more about costs, opportunities and their own effort than shareholders do, so shareholders cannot easily monitor whether managers are maximising profit, and managers can pursue their own goals without being detected.. Say who knows more, why that stops monitoring, and what the agent can then do.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (XEC11/YEC11), Unit 3 Business behaviour and Appendices 6 and 7

Last updated 8 November 2026. Spotted a mistake? Tell us.