Conflicts of interest between shareholders and managers of a firm result in: A) Increased agency costs B Managers owning the firm C) Principal-agent problem D) Both A and B
The correct answer and explanation is:
Correct Answer: C) Principal-agent problem
Conflicts of interest between shareholders and managers of a firm result in what is known as the principal-agent problem. This issue arises when the goals of the principals (shareholders) do not align with those of the agents (managers), who are hired to operate the business on behalf of the owners.
Shareholders are typically interested in maximizing the value of their investment. They want the company to operate efficiently and generate high returns. Managers, on the other hand, may have different personal goals such as increasing their compensation, job security, or enjoying perks of the position that do not necessarily benefit shareholders. When these interests diverge, decisions made by managers might not reflect the best interests of the shareholders.
The principal-agent problem becomes more pronounced when there is asymmetric information. Managers usually have more information about the daily operations and performance of the firm than shareholders. This information gap makes it difficult for shareholders to monitor managers effectively, increasing the risk of self-serving behavior.
One consequence of this problem is the creation of agency costs. These are costs incurred to monitor managerial behavior, align their interests with shareholders, and prevent the misuse of company resources. Examples include performance-based compensation, audits, and corporate governance mechanisms.
While agency costs are related to the principal-agent problem, the term specifically refers to the expenses involved in mitigating the conflict. The principal-agent problem is the root cause. Therefore, the best choice in the context of the question is C because it directly names the overarching issue caused by conflicts between shareholders and managers.
To address this problem, firms may use incentives like stock options, performance bonuses, or threats of removal to encourage managers to act in shareholders’ interests. However, completely eliminating the principal-agent problem is challenging.