A particular case of asymmetric information is where one person, who we call the principal, wants to get another person, who we call the agent, to do something on their behalf. This situation is known as the principal-agent problem, or more simply just the agency problem.
Consider a person with some spare money, thinking of investing it in the shares of a company. They will have two questions: one, is this is a potentially good investment, meaning that the expected returns compensate for the expected risk; and two, even if it appears to be, can I trust the chief executive to act effectively to make those investments actually happen?
This is an agency problem, because the outside investor has imperfect information about how the CEO actually behaves. If that investor isn’t confident in the skill and motivation of the CEO, then he or she will not put their money into the shares.
In other words, unless we can solve the agency problem to a sufficient degree, there won’t be any investment in companies where we don’t have personal knowledge of, and trust in, the CEO.
In fact in many countries that is the reality. We observe limited amounts of external investments in companies, and usually only where the investors know the CEO directly or are family members. This means that a lot of potentially valuable investment opportunities don’t get funded and the economy doesn’t grow or develop as much as it otherwise would.
Indeed, one definition of a more advanced or developed economy is that it is one that has solved, at least to a reasonable degree, the agency problem. In the early 20th century, the US economy’s growth was increasingly driven by large companies that had outgrown their original founders. This meant that ownership of the company (by external shareholders) was separate from control (by professional managers). This gave rise to a widespread agency problem, but US capitalism evolved ways to resolve the problem, along the lines below.
So how might we manage this agency problem?
The core of the problem is the fact that the CEO knows whether he or she is skilled and motivated to work hard, as opposed to either stealing the investor’s money or just wasting it on a fancy office and unnecessary corporate jets. But the potential investor doesn’t know this. In other words, this is a case of asymmetric information.
So there are two possible solutions to this problem, which are not mutually exclusive.
The first is to reduce the asymmetry of information by putting in place arrangements that make it harder for the CEO to either shirk responsibility or waste the investor’s money. This could include having a board of directors to which the CEO must be accountable, including performance reviews and scrutiny of the CEO’s actions.
This is part of what is called corporate governance, a set of institutions and procedures that are intended to ensure that outside shareholder’s interests are protected.
Of course, in addressing one agency problem, that between the investor and the CEO, we have created another, between the investor and the board of directors. Company directors are legally responsible for looking after the external shareholders’ interests, but it’s hard for those shareholders to tell whether they are really doing so, again because of asymmetric information.
Directors have to be elected at annual general meetings, and to produce annual reports, all of which gives shareholders some opportunit to check whether they are the right kind of people to do the job. But it’s hard to be completely sure, when something goes wrong, whether it was genuine bad luck, or instead the directors weren’t really paying attention.
So a second way of addressing the original agency problem between the investor and the CEO is to incentivise the CEO to behave in the way that the investor wants. If the goal is to maximise shareholder value, by taking actions that will raise the value of the shares, then it makes sense to give the CEO a contract that links his or her compensation to the value of the shares, including share options or even direct grants of shares. If the CEO is, in effect, a shareholder, then presumably he or she will be motivated to raise the value of the shares. We can then say that the interests of the shareholders and of the CEO are aligned, and the agency problem is reduced to a manageable level.
If outside shareholders believe that the combination of board scrutiny and an appropriate contract will ensure that the CEO will indeed act in the shareholders’ interests, then they may be willing to invest in the company. The agency problem is overcome, and therefore investment takes place.
It is because the agency problem can in reality only be managed, rather than completely solved, that the actions of CEOs are carefully scrutinised. The problem of asymmetric information can be reduced to the point that investors do actually put money into a company, but it can never be perfectly resolved.
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