1Why does the evolution of large firms lead to a principalag

1.Why does the evolution of large firms lead to a principal-agent problem?

2. How can the principal-agent problem between owners and managers be minimized?

please provide links to any websites you use for reference. thank you

Solution

(1)

When a firm remains small, it can be managed by very few people. The relevant firm structures are proprietorship (when one person owns the firm) and partnerships (where more than one partners jointly own the firm). Under these structures, owners are managers since the owners find it possible to look after, run and monitor all business aspects.

But as a firm becomes larger (a corporation), number of employees and scale of operations both go up, making it impossible for the owners to run and monitor every business aspect. This lack of manageability makes the owners hire managers to run the business in favor of the owner\'s best interests.

The principal-agent problem arises when the agents (managers) take decisions that are not to the best interest of principals (owners). Instead, the agents act to maximize their self-interest even if such act is in direct contradiction to the principals\' interest.

This is why, evolution of large firms lead to principal-agent problem.

(2)

This problem may be mitigated using following measures:

(a) By agreeing to share a percent of firm\'s profits, principals can make the agents\' goals align to the principal\'s goals, since the higher the goals are aligned, the higher the profits and the higher the agent gains.

(b) Performance evaluation is another method. Regular appraisal of agent performance will help the principals identify existence of principal-agent problem, and since the agents will be aware of workings of the evaluation results, they will tend to minimize non-alignment of goals.

(c) Non-profit incentives (higher benefits which are tied to firm\'s performance) will encourage agents to align their goals to their principal\'s goals and act accordingly.

Note: No website has been referred to or ay online resources used/referred to/copied. I\'ve answered from my own Economics knowledge.