3.2.1 The principal-agent problem

• What is the principal-agent relationship?

  Delegation of decision-making authority
• 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:

  1️⃣ Performance-based contracts: Align incentives

  2️⃣ Monitoring and oversight: Ensure compliance

  3️⃣ Transparency and communication: Foster trust