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B. Venkatesh

YOU may have observed that employees of several technology companies are now exercising their stock options. But did you know that stock options are incentives given to the employees to moderate the principal-agent problem?

A principal-agent problem arises when work is delegated. Suppose you run a business with 100 employees. Your employees interact with customers and suppliers on your behalf to manage the day-to-day affairs of the company. You are the principal and the employees, your agent.

The problem is that the employees may not be maximising the company's profits. For instance, the person buying raw material may not be scouting for the best possible price and quality. As a principal, you may not be aware of all the work that you have delegated. This principal-agent problem is referred to as the hidden action problem or moral hazard. What will you do? Naturally, you will provide incentives that will make the employees maximise profits. You may, for instance, choose to share a proportion of profits if the company does well.

Now transport this logic to companies listed on the stock exchanges. If a company does well, so should its stock. That is one reason why companies issue stock options to employees as an incentive to moderate the principal-agent problem. In this case, the shareholders are the principal, and the employees, their agents.

There is another kind of principal-agent problem called the hidden information problem or adverse selection. You encounter this problem every day. Suppose you take your automobile for servicing. Your agent, the mechanic, knows more about the condition of the vehicle than you do. His objective then would be to service the automobile in quick time, and yet charge more. As in the case with the hidden action problem, you need to provide incentives to ensure good service at not-so-high cost.

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The principal-agent problem

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