The principal-agent relationship arises when one party (principal) delegates decision-making authority to another (agent).authority
Match the roles with their responsibilities in a principal-agent relationship:
Principal ↔️ Sets objectives
Agent ↔️ Manages the business
The principal-agent problem occurs when the agent’s goals align with the principal’s objectives.
False
What is a common example of a principal-agent relationship?
Shareholders and CEO
Conflicts of interest in the principal-agent relationship arise when the agent’s priorities do not align with the principal’s objectives.objectives
Match the conflict type with the principal’s and agent’s interests:
Shirking ↔️ Maximum effort ||| Minimal effort
Risk Aversion ↔️ Higher profits ||| Job security
Information Asymmetry ↔️ Full transparency ||| Withholding information
What is the primary cause of conflicts of interest in the principal-agent relationship?
Agent prioritizing personal goals
Asymmetric information occurs when the agent has more knowledge than the principal.
Moral hazard arises when the agent engages in riskier behavior without the principal’s awareness.hazard
What is adverse selection in the principal-agent relationship?
Hiring an unskilled agent
Shareholders (principals) hire a CEO (agent) to maximize profits, but the CEO might focus on short-term job security or higher salaries, leading to actions that don't align with the shareholders' long-term objectives. This is known as the principal-agent problem.problem
Why do conflicts of interest arise in the principal-agent relationship?
Varying incentives and goals
Information rent occurs when the agent extracts excess benefits due to superior information.
Moral hazard occurs when an agent, protected from the full consequences of their actions, takes on more risk than if they were fully accountable.accountable
What is an example of moral hazard in the principal-agent relationship?
Executive approving a high-risk investment
Adverse selection arises when the principal lacks full information about the agent’s skills or intentions before entering into an agreement.agreement
What is moral hazard in the principal-agent relationship?
Excessive risk due to protection
Moral hazard can lead to financial instability
Adverse selection arises when the principal has full information about the agent's skills before forming an agreement.
False
Match the roles with their perspectives in adverse selection:
Principal ↔️ Seeks a skilled and committed agent
Agent ↔️ Hopes to be chosen despite limitations
What is the principal-agent relationship in business?
Delegation of decision-making authority
The potential for conflict in the principal-agent relationship is called the principal-agent problem
Asymmetric information occurs when both the principal and agent have equal knowledge.
False
What are three effects of asymmetric information?
Moral hazard, adverse selection, information rent
In the principal-agent relationship, when does moral hazard arise?
Agent takes excessive risks
Adverse selection occurs when the principal lacks information about the agent’s abilities
Agents always prioritize profit maximization over personal goals in the principal-agent relationship.
False
What is a performance-based contract designed to do in the principal-agent relationship?
Align agent’s interests with principal’s
Order the strategies to mitigate the principal-agent problem based on their primary goal: