What Type of Agency Problems Do These Incentive Schemes Address?

Q3 What type of agency problems do these incentive schemes address?

The agency problems arises between manager and shareholder, when both of them have different incentives and different welfare maximization. Shareholders are the principal hiring a manager, the agent, to lead the organisation perform some service in the best interest of the principal with the main incentive to maximize shareholder value. However, the manager is rational and finds that his own incentives is more important. All agency relation problems have the same basis; there is an information asymmetry between the two parties Due to information asymmetry, the shareholders cannot get all the decisions made by the manager. This asymmetry contributes to behavioural problems of managers like consumption on the job. The agency costs arise when managers do not bear the full consequences of their decisions. This kind of behaviour also contributes to decrease the operating performance which also reduces firm value because of the costs associated with this behaviour.

        The agency problem between managers and shareholders may also occur in difference point of  view of risk perspective. For example, Manager would reject some positive NPV project because managers are being risk-averse. However, shareholders are willing to take the risk because they can diversify their risk by using portfolio management. This difference in attitude towards risk can enlarge the agency problem, because it creates different incentives between the manager and the shareholder. The manager’s risk aversion also implies that manager will like to compensate in a structured way to minimize his personel risk, with the consequence a manager will prefer fixed pay compensation rather than equity-based compensation. From a shareholder perspective, this difference in incentives by managers and shareholders can minimize by linking compensations to firm performance. Therefore, the manager are encouraged to considering to maximize firm value when making decisions.

        However, CEO  remuneration can also create agency problem. which the CEO does not put firm performance as his first priority and the CEO is rather looking to serve personel interests through gaining prestige and greater remuneration. CEO with larger power are looking for compensation in ways that are not necessarily consistent with firm performance. In this way the compensation does not solve the agency problem and may even make the problem worse because the CEO can use their powers to dictate their compensation while company is performed less. For example, if a CEO’s performance is linked with the company’s product sales. This will encourage the manager to expand the firm so that can produce more number of product to boost the number of sale above the optimal level without looking at the cost associated in order to get his pay.