Question

When business performance depends on both a manager's effort and on random economic fluctuations, an owner deciding how to compensate that manager faces a trade-off: The manager can be motivated to exert more effort, but doing so requires forcing the manager to bear more risk. What do we call this trade-off?

	A.	The principal-agent problem.
	B.	The principle components problem.
	C.	The principal-teacher problem.
	D.	The runcible spoon problem.

Answer 1

Answer - (A) Principal-Agent Problem.

The principle agent problem arises when one party (agent) agrees to work in favor of another party (principle) in return for some incentives. Such an agreement may incur huge costs for the agent, thereby leading to the problems of moral hazard and conflict of interest. Owing to the costs incurred, the agent might begin to pursue his own agenda and ignore the best interest of the principle, thereby causing the principal agent problem to occur. In the example above, the owner wants to make the manager work towars the owner's interests so as to imrove the business performance but for that managers need to be encouraged to take on some risks which can only be made possible by offering incentives on risk taken.