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Managerial Economics_Module 9 Assignment

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Q 1. Explain how principal-agent relationships can lead to incentive conflicts. 2. Analyze bad decisions using the three factors of who makes the decision, who has the information, and who has incentives. 3. Describe how transfer pricing between divisions can lead to less profitable organizations. 4. Explain how vertical integration can reduce incentive conflicts.

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The problem of principle agent occurs when it is agreed by one party (that is the agent) to function in support of the other party (that is the principle) in return for certain incentives. Huge costs may be incurred by such a contract for the agent. This causes interest conflict and moral hazards problems. The problem occurs when an environment is created by a principal where incentives of agent aren’t aligned with the incentives of the principle. The onus is generally on the principal for incentives to be created for the agent in order to make sure that they function as wanted by the principal.