Answer to Question #143510 in Economics of Enterprise for umair

Question

The shareholder of Al-Karam wants to maximize his profits by selling his goods in the larger quantities. In order to achieve his target (s) he hired a manager to look after his business. However, the manager instead of maximizing business profits started maximizing his own interest by selling the designs in black to the competitor’s designers. Analyze the above situation and explain the possible problem that might occur for Al-Karam.

Answer 1

The problem Al Karam faces is a principal agent problem since the agent is acting in his own self interest as opposed to the interest of the business. It is a moral hazard problem.

He needs to fix this by creating incentives that force the agent to act in the best interest of the business. He could link the agent's pay to the performance of the business in order to counter the moral hazard.

The agent in this situation is the manager.