Principal-agent problems arise through the misalignment of interests between individuals or groups within an organisation. They can occur in various parts of an organisational structure, for instance in Labour; between an employer and an employee, Franchises; the franchisor and franchisee, Regulation; the regulator and the regulated company through to Investors; between the Shareholders and company Executives (Fingleton, J. 2012) The strength and alignment of these relationships are vital for the smooth successful operation of organisations, problems can occur in both the public sector in healthcare through doctor-patient-pharmaceutical company relationships and also in government, whilst more commonly known in the private sector through labour and investor related problems.
This report will evaluate the effects of the principal-agent problem within firms by considering real world examples of where they may have occurred and what methods organisations use to address the issue.

Empirical Evidence

Empirical evidenceThere is however considerable empirical evidence of a positive effect of compensation on performance (although the studies usually involve “simple” jobs where aggregate measures of performance are available, which is where piece rates should be most effective). In one study, Lazear (1996) saw productivity rising by 44% (and wages by 10%) in a change from salary to piece rates, with a half of the productivity gain due to worker selection effects. Research shows that pay for performance increases performance when the task at hand is more repetitive, and reduces performance when the task at hand requires more creative thinking.[2]

Paarsch and Shearer (1996) also find evidence supportive of incentive and productivity effects from piece rates, as do Banker, Lee, and Potter (1996), although the latter do not distinguish between incentive and worker selection effects.
Fernie and Metcalf (1996) find that top British jockeys perform significantly better when offered percentage of prize money for winning races compared to being on fixed retainers.
McMillan, Whalley and Zhu (1989) and Groves et al. (1994) look at Chinese agricultural and industrial data respectively and find significant incentive effects.
Kahn and Sherer (1990) find that better evaluations of white-collar office workers were achieved by those employees who had a steeper relation between evaluations and pay.
Nikkinen and Sahlström (2004) find empirical evidence that agency theory can be used, at least to some extent, to explain financial audit fees internationally.
There is very little correlation between performance pay of CEO's and the success of the companies they manage. [3]
Margiotta and miller – shell – how can be aligned
Utility Maximisation – > enron – bring into shell case – William H Nelson – maybe bring to solutions
Efficency wage – problems -

Case 1 - Mondragon

Expanding on the labour example problems can transpire when work has been delegated from an Employer (the principle) to the Employee (the agent) especially when they have different interests or objectives (Laffont, J. Martimort,D. 2002). For example the employers will most likely have profit and productivity on their minds, however the employee may just be working for the money or with little motivation and effort to do any work and ultimately underperform otherwise known as ‘Shirking’ . The result can mean the agent can advance their own interests ultimately at the expense of the principal creating a moral hazard in possibly escaping the sack due to employment law, and the company suffering long term. Many employers act to limit the effect of the problem, however it can be very costly in terms of time and resources (Abdalla,K) Due to the high costs associated with aligning interests, for years economists and companies have been developing cost-effective incentives to combat the problem, however some firms are structured in ways they feel combat the problems.
Of particular interest to this type of principal agent problem is the Spanish Corporation Mondragon. With one firm and a workforce of 25 in 1956 to an international 100 business strong co-operative owned by around 34000 employees in 1998 it is a very unique organisation (Freundlich,F. 1998) Combined with years of proven success they also pride themselves on giving back to communities and developing young talent, investing in technological research centres, new high schools, colleges and social security systems.
What differentiates Mondragon from its competitors is its overall productivity and extremely high level of employee growth represented by a staggering 80000 strong workforce more recently in 2007. One study taken by Levin in 1983 found that in the 1970’s the average co-operative used only 25% as much capital equipment per worker but worker productivity reached 80 per cent of that in the private sector (Wilber, C. 1998) The author also goes on to relate worker motivation to the cause, he claimed that as workers became real shareholders in the company and took part in decision making situations and managerial responsibilities the incentives to shirk were dampened. This demonstrates that as employees may have had a tendency to shirk on the job in the shorter term, higher levels of effort and concentration would benefit them personally in the longer term, which is one step to combat the conflicts of interest between parties. To this day the organisation is still based on its core co-operative principles with a one member one vote approach (Lehki et al) Having the Employee Share Ownership Programme (ESOP) in place can bring significant democratic gains to a firm in addition to promoting a greater sense of commitment and equality and a feeling of being wanted amongst employees (Davies, W.2009) This incentive has kept staff motivated and maintaining high levels of productivity within Mondragon. In 2003 the company was voted in the ten best firms to work for in Europe, based on its commitment to equality and participatory governance (Silver B, 2004).
As mentioned in the Mondragon case productivity has been kept high and constant, as mentioned by Kruse 2002, who states “Productivity improves by an extra 4-5% on average in the year an ESOP is adopted and the higher productivity level in maintained in subsequent years” (Kruse, D. 2002) The author also states the estimated productivity difference between ESOP and non ESOP firms is around 6.2%, displaying a strong linkage between employee incentives, motivation and overall productivity.
Some firms have gone to excessive lengths to monitor employee’s and prevent shirking during working hours. In the US some firms are installing GPS software within company owned equipment the employee may use such as phones and vehicles (Still, K 2011) This is a cost effective method of employee monitoring however as stated by the author above has raised privacy issues which have been tried and resulted in bans for some regions.

Case 2 - Shell

Misaligned interests can also occur between other stakeholders in firms. One principal agent problem which is very common in organisations is the misalignment of objectives between the executives and shareholders. Shareholder’s interests are in their stake within the company and are focused on generating big profits for large personal returns; however they delegate the running to managers to bring them. Managers are working for this success but also have personal aims, which can create conflicting interests particularly when the agent (the executive) have power and large remuneration packages available.
A recent example of this was demonstrated within Royal Dutch Shell Group. The majority of Shell’s operations are in the oil industry. Within oil companies current performance and company value is based not only on profits but also in the amount of oil reserves they own which can ultimately determine the share price. “On January 9th, Shell said that it was downgrading nearly four billion barrels of oil and gas—a whopping fifth of its total reserves—from “proven” reserves to “probable” or other, even less-certain, categories” (Anon,The Economist, 2004) This was a sudden shock to the energy industry worldwide and especially the shareholders, who saw their shares drop immediately by around 7% (Shubash et al. 2009). Later that year an internal review was undertaken on in the company, which leaked that top executives had known about the inflations for years, ultimately using their power to overstate the reserves and exploit the share ownership system for personal gain. This indicates though incentives are used to prevent the principal agent problem they can also be the catalysts. We can also highlight the problem of asymmetric information between parties here. The shareholders were continually unaware of the statements despite years of annual company reports there was very little honest disclosure. One study showed that every publication words were carefully selected to hide the evidence and show language which would point to other successes or issues in the company and not the reserves ultimately attracting little attention to the issue. (Martinez, Crowther. 2008).
In the case of the late US energy company Enron, personal welfare interests of managers have reached new heights. Executives were acting consistently to benefit themselves whilst on the job through the use of company aeroplanes and luxurious offices, this could be down to them having little stake in the business and their way of getting something back in other words they were maximising utility or the satisfaction of the job (Moyer et al. 2008) This is often done at a discretionary level but in one situation the Enron board had instructed its CFO Andrew Fastow to set up individual partnerships that purchased assets to help align the risk of the company in parallel making him personal millions. Ultimately the investments went bad which along with other severities tipped Enron on the downhill trail.