Is defined as a conflict of interest between the corporate shareholders and the corporate managers

Principal Agent Problem (Agency theory)

Explanation:

Definition:

Principal agency problem is when there is a conflict of interest between the agent(corporate managers) and the principal(shareholders). It occurs when agents act in their own interest and not that of the principal.

The separation of ownership between the shareholders and mangers creates the conflict of interest between the parties.

Solutions to Principal Agency Problem:

1. Contract design - Addresses information asymmetry by insuring that managers contracts have incentives that stimulate them to act in the best interest of the shareholders.

2. Performance evaluation and compensation - In order to align interest of both parties, compensation must be linked to the performance of managers.