Chapter 21 Main Points · Principals want agents to work for their (the principals’) best interests, but agents typically have different goals than do principals. This is called incentive conflict. · Incentive conflict leads to moral hazard and adverse selection problems when agents have better information than principals. · Three approaches to controlling incentive conflict areIn a well-run organization, decision makers have (1) the information necessary to make good decisions and (2) the incentive to do so. · Fixed payment and monitoring (shirking, adverse selection, and monitoring costs), · Incentive pay and no monitoring (must compensate agents for bearing risk), or · Sharing contracts and some monitoring (some shirking and some risk compensation). · If you decentralize decision-making authority, you should strengthen incentive compensation schemes. · If you centralize decision-making authority, you should make sure to transfer needed information to the decision makers. · To analyze principal–agent conflicts, focus on three questions: · Who is making the (bad) decisions? · Does the employee have enough information to make good decisions? · Does the employee have the incentive to make good decisions? · Alternatives for controlling principal–agent conflicts center on one of the following: · Reassigning decision rights · Transferring information · Changing incentives The Principal-Agent Problem The last three chapters that we will discuss revolve around the Principal-Agent Problem. In the principal-agent problem, there is one entity, the principal, who wishes to have someone else, the agent, perform some actions for him. The problems associated with the principal-agent relationship arise from the fact that the principal and agent have different incentives. Thus, the principle may wish the agent to take some action but it is in the agent’s best interest to perform some other action. We will study situations in which the principal-agent problem arises and examine potential solutions to the problem. In this chapter the agents will be employees and the agents are either their direct supervisors, higher-level managers or the owners or shareholders of the company. In Chapter 22, the agent will be a division of the firm, and in Chapter 23 the agent will be a vertically-related but separate business. Principle-Agent Relationships in Firms Stockholders and owners have one goal for the firm: maximizing profits. They want everyone associated with the firm to make decisions with a focus solely on the profit of the firm. The CEO and board members likely share the desire for the firm’s profitability, perhaps through incentives in their contracts, but the board and CEO have additional motivations beyond the firm’s profitability. Among their motivations may be keeping their jobs, accumulating power, and accumulating the trappings of the position. This may cause the CEO to make sub-optimal decisions as far as the stockholders are concerned. Further down the .