Essay Sample: The Principle-Agent Problem's Contribution to Crises

Published: 2022-05-13
Essay Sample: The Principle-Agent Problem's Contribution to Crises
Type of paper:  Essay
Categories:  Financial management Crisis management
Pages: 7
Wordcount: 1913 words
16 min read

The principle-agent problem is the situation whereby one economic subject, say an individual or a firm or a company have another commercial theme that the work is delegated to on his or its behalf. The item that delegates duties are referred to as the principle, while the second subject is the agent. The agent always decides to benefit the principle. Since the principle cannot be able to adequately monitor the agent, there is the involvement of the incentives to motivate the agent to work. It works with the belief that the effort that the worker will put in the production is partially dependent on the rate of income. According to (Grossman and Hart 1983, p.9), it has been recognised that in the presence of the moral hazard, the market allocation under the uncertainty will not be unconstrained Pareto optimal. The principle or the economic subject that is profit maximising should then consider setting the rate of the agent's income, to be proportional to the effort put in the productivity. The advantage yielded from the firm is usually assumed that it is dependent on the agent who manages the firm as well as other factors that is out of the agent's control. The problem brings out the conflict of interest as the agent's interests may differ from those of the principle, hence several strategies have been set to mitigate the problem in various firms.

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The principle-agent problem is believed to be occurring in any firm or organisation whereby delegation is involved. Consistent with (Elson and Gyves 2003, p.855), it has been realised that the minimal time allocated for monitoring of the firm is what causes the principle-agent problem hence in every company where the owner or the shareholders do not directly monitor their company progress, there must be the rise in a principle-agent problem. Following the economic theory of information in the research paper by (Downs and Rocke 1994, p.370), it was revealed that the agents are usually characterised by the private information which determines their ultimate productivity. The agent is often more informed about a critical activity taking place in the firm as compared to the principle. This is because of the long-term exposure in the firm and interaction with the other factors involved in the production. Due to this factor, the interests of the agent and principle usually conflict in one way or the other. The system, however, has contributed to several problems that occur in the firms or organisations such as financial crises. Some issues arise from the situation whereby the principle has got more than one agent, and he is not able to distinguish between the two. The primary focus of the paper is to provide ways in which the principle-agent problem have contributed to the crises, for instance, Enron failure and financial crisis of 2008.

The Enron Failure

According to (Haubrich 1994, p.259), it was stated that the Enron Company originated back in the year 1985 when it started with a humble background as a merger of the natural gases, coal, and steel. Its founder is known as Kenneth Lay who started the company in Omaha Nebraska. The Headquarter was later moved to Houston Texas by Kenneth Lay. The company incurred enormous debts in the merger process which led to its denial of its exclusive rights to access the pipeline in any way. For the company's survival, the decision of making a new business strategy as adopted and the contract given to Skilling who was an analyst as well as the economist. He was believed to have an excellent economic background more so in handling an issue like Enron's. The revolutionary solution that was developed was that Enron was to buy gas from a series of companies an sell it to different consumers, both large scale, and small scale. This enabled the company to create the gas bank as well as making the sales and the price at the same time. Skilling created the new division in the year 1990, known as Enron Finance Corp, which became very famous in the market and enabled the company to gain back its trust to the consumers (Catanach and Rhoades-Catanach 2003, p.1057). Enron made more profit than the other competitors hence this made its first success to lift up the company's name. In line with (Linthicum, Reitenga and Sanchez 2010, p.165), it is recorded that the first Enron's tragedy began when the company made a loss of $90 million within a short period of five days due to the traders gambling with the company's assets to maximise the profit. This sent away the investors and the firm's auditor decided to save the company's name by bluffing the numbers and giving out the wrong figures about its profit and loss, to continue keeping the consumers' trust.

When Skilling managed Enron, the company accepted to adopt the new financial accounting form known as mark and market whose liability is based on the current market. This also contributed to the struggles of the company's stakeholders to revive it again. In the process of restoring the company, Skilling brought up a crazy system of the Darwinian natural selection of ranking the employees which made at least ten employees be fired every year according to their productivity as stated, (Vinten 2002, p.7). The firing of employees made a negative impact on the employees' life as well as the name of the company. The traders started withdrawing slowly by slowly from the company in fear of their shares in case the company collapses. In the ten solid years, the company was said to be too good to be true since its dealings were perfect as the company assumed several risks for the sake of the market, as stated (Sannikov 2008, p.957). As the time goes by, the company started collapsing as a result of duty delegation to several people who had their methods of maximising the profit to the company. The year 2001 marked the high fall of Enron Company under the hands of Jeff Skilling who left two days before the company collapses. There are several reasons stated for the collapse of Enron.

How Principle-agent Problem contributed to the Fall of Enron

In line with the study done by (Holmstrong and Milgrom 1991, p.24), the major contributing factor to the failure of Enron Company is the Principle-agent problem, whereby the duties were being delegated to people hence the shareholders could not have the direct monitoring of the company. Kenneth Lay who was the founder of Enron hired an analyst, and a PhD student in economics to take care of the company. This means that the founder needed to increase the rate of incentives to motivate the efforts of the work input by the workers. The people whom the duties were delegated to turned to be greedy, benefiting their interests. The bonuses were paid to the stakeholders with the expectation of realising the profits that were never realised until the fall of the company. The people who were in charge mishandled the new revenues that the company developed which would sustain the company's income for the success of the company. The revenue stream ended up being maintained in an unethical manner and even the illegal dealings with other companies which posed several risks to the business. The employees were also manipulated in different ways to maximise the profit and make bonuses without the incentives hence low productivity due to lack of motivation ( Thomas 1990, P.369).

According to (Linthicum et al. 2010, p.165), the employees were also manipulating the values hence giving the wrong figures concerning the profit as the executives, on the other hand, perpetrated the culture system thus at the end; the shareholders were left without anything. The incentives were also directed to both the workers and the executives which lowered the illegibility of the company amongst other companies. When the workers needed to put more effort in the productivity of the company, there was the bluffing of numbers in their annual reports concerning the company. This wrong figures painted a different picture of Enron Company in the outside market yet that was far from what it was. The company continued perpetuating its losses year in year out till it reached a point of no return. The stakeholders and the managerial had seen the dim future of the company and other staff members decided to jump out of the sinking ship to avoid blame for collapsing the company (Abdalla 2008, p.6). Some members such as Skilling, Sherron, and many others left the company after the realisation that the suggested amendments to the company's financial status could not work anymore. In the mitigation plan of the company, these staff members are the ones who should be answerable of the company's collapse and the significant loss of finance that the company faced.

The other problems that Enron experienced as a result of the principle-agent question are in the accounting. These problems were realised in late 2001 when the new businesses were found not to be performing at the expected standard in the market. This is because Enron started very many companies and put people in-charge expecting to yield the maximum profit to maintain its rank in the current market. Some of the activities include the Azurix which was the water company and it was announced in the year 1998, as well as the broadband investment among others. A tragedy was when all the businesses were allocated millions of dollars, yet some of them did not pick up to yield the expected profit. The total amount of money that was allocated for the small investments added up to 22% of all the expenditures in the Enron Company in a period of three years that is from the year 1998 to 2000, as researched by (Cvitanic and Zhang 2013, p.4). This made the company to sell some of the investments at a lower price than they purchased it to regain back some of the lost finance. This is observed when the company was forced to sell the Portland General Corp., which was an electric power plant that the company acquired in the year 1997 at a loss of about $1 billion. The Capital markets then started ignoring the Enron Company's alarm on some issues as its fall was nearing.

The fall of Enron Company is considered to be a direct result of the failure of the corporate governance which could occur to any profit-making company or organisation (Malcomson and Spinnewyn 1988, p.398). Some arguments have it that Enron Company was a manifestation of the principle-agent problem, and the high-powered incentives that were given only benefitted the managerial for their self-dealings hence the lower tier workers lacked motivation and slowed down on profit making. The significant costs which resulted from the company were then transferred to the shareholders hence lack of the firm board independence; the company experienced the condition known as the management rent extraction. The main aspects of the oversight function should be a necessity that is assigned to every company to avoid stunning the investors as in the case of Enron. The company designed the compensation technique to refund the stakeholders to alleviate the principle-agent problem in their plan to revive the company again. Despite all the efforts that the stake-holders of Enron Company tried out, there were still gaps left in some places hence the company could not reach where it was before. The competitor companies had already taken advantage of the fallen state of Enron Company.

During the time which Enron collapsed, there were very many companies that were bankrupt including WorldCom (Litan 2002). However, Enron's bankruptcy surpassed that of all the other companies.

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