Principal-agent theory provides definitive answers to how ownership Essay

Principal-agent theory provides definitive answers to how ownership and control problems should be overcome in particular firms - Essay Example As Lane indicates, the analysis of multifaceted private contracting initiated the development of the principal-agent theory. A difference can be made between temporary contracting as with the buying and selling of goods on the one hand and continuing contracting on the other hand whereby an individual hires another individual or group of individuals to work for them against compensation (2). A principal-agent correlation is a contract in which one or more individuals appoint another individual to carry out some service on their behalf whereby the former is the principal and the later is the agent. This entails entrusting some decision making power to the agent which is fairly common. For instance, a homeowner (principal) may employ a carpenter (agent) to repair her table while a client (principal) may hire a lawyer (agent) to defend his case. Principal-agent correlations also normally arise within organizations, even though the above two examples describe relations in a private setti ng. In organizations, the role of the principal is often played by the board of directors, which contracts a manager to manage the institution in the interest of the investors or in the interest of the stakeholders in the case of a nonprofit organization (Caers et.al, 26). Principal-agent theory is used to portray a dyadic relation between a buyer and a seller. At its most basic levels, this model originated from economics. In this relationship the buyer makes a deal with the seller and has the finances to acquire the seller’s service of the service. This means that the buyer has the control required to fund and realize the service that they require. Conversely, the seller can push the association to their favor and increase the price since they have more knowledge concerning the service they are providing than the buyer does. However, either the seller or buyer can employ this to their benefit depending on phrasing of the contract. Principal-agent theory assumes that the sel ler and the buyer do not yearn for a jointly beneficial result of the association, but would somewhat pay less or charge more than what the other is offering (Cohen, 5) In a principal-agent interaction at least two people are to partner in the formation of a service that has value. However, the two individuals are not of the same legal standing or partners. The agent is the individual who works for the principal while the principal puts up the payment for agent’s effort against the value that the agent gives to the principal in the form of a product of some sort. Consequently, principal-agent interaction is basically an agreement on how much of the value that the agent produces should go back to him/her as an earning. Nevertheless, what makes the principal-agent model unique is the extra assumption of asymmetric information, meaning that the agent knows more than the principal about the service under consideration in a manner that may influences the contracting results (Lane, 2). In the principal-agent model, the payoff to the principal relies on an action taken by the agent. The principal cannot contract for the action, but can pay off the agent founded on some evident sign that is associated with the action. The first mover is the principal who decides an incentive system for paying the agent depending on the apparent sign. On the hand, the agent decides the best action to take, given the incentives, and then chooses whether to accept the principal’s offer, based on the estimated payment and the prejudiced cost of carrying out the action. Upon agreeing, the agent decides an action that makes the most of his remunerations and the principal monitors the signal associated with t