Managerial Economics - Christopher R. Thomas-S. Charles Maurice

CHAPTER 1 Managers, Profits, and Markets 21
known as uniform pricing. In Chapter 14, we will show you several advanced
pricing techniques, which charge different buyers different prices and generate
even more revenue than with uniform prices.
These are just a few of the many mistakes we will teach you how to avoid. Don’t
be concerned at this point if you’re not sure you understand these mistakes—we
guarantee you will by the end of the text!
1.3 SEPARATION OF OWNERSHIP AND CONTROL OF THE FIRM
principal–agent
relationship
Relationship formed
when a business owner
(the principal) enters
an agreement with an
executive manager (the
agent) whose job is to
formulate and implement
tactical and strategic
business decisions that
will further the objectives
of the business owner
(the principal).
Business owners frequently choose to delegate control of their businesses to a professional
executive or senior manager who will typically be assisted by additional
subordinate managers, which creates an executive management team that relieves
the owners of management duties. Only in the smallest business organizations—
typically sole proprietorships, smaller general partnerships, and family
businesses—are you likely to see owners managing their own businesses. The
decision to hire professional managers creates a separation between business
ownership and its management. This separation forms a special relationship between
business owners and managers known as a principal–agent relationship.
In this particular type of principle–agent relationship, a business owner (the
principal) enters an agreement with an executive manager (the agent) whose job is
to formulate and implement tactical and strategic business decisions that will further
the objectives of the business owner (the principal). 7 The agency “agreement”
can, and usually does, take the form of a legal contract to confer some degree of
legal enforceability, but it can also be something as simple as an informal agreement
settled by a handshake between the owner and manager.
Separating ownership and control of a firm holds the potential to significantly
increase a firm’s value, especially when it replaces “amateur” owner-managers
with more experienced and talented professional business decision makers. In
practice, however, some or all of the potential gain to the owners from hiring expert
managers can be lost when owners cannot prevent managers from behaving
opportunistically by taking self-interested actions that are harmful to the owners.
We will now discuss this fundamental problem arising from the separation of
ownership and management and examine some ways to solve or at least control
the severity of these problems.
The Principal–Agent Problem
A fundamental problem that frequently, but not always, afflicts the principal–
agent relationship between business owners and managers occurs when a
manager takes an action or makes a decision that advances the interests of the
7
We are employing here a rather specific definition of the principal–agent relationship to focus
on the agency relationship between a firm’s owners and the firm’s executive managers. Business
organizations typically form a variety principal–agent relationship in addition to the one between
owners and executive managers that we are discussing in this textbook. Several other examples of
principal–agent relationships include CEOs and other executive officers (CFO, CIO, and COO), the
boards of directors and CEOs, and CEOs and middle managers.