Market Failure: Principal-Agent Problem

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Market Failure Type 4
The idea of market failure is essential to economics because it aids decision-makers in determining the causes of market failure, and developing practical solutions to address the problem. There are different market failures, and this essay will summarize the principal-agent problem in financial markets, explore its causes, and provide examples to illustrate the concept.
The principle-agent problem is a market failure that develops when the interests of the principal (the owner or manager of a firm) and the agent (the employees or managers who run the firm) are not in harmony. The agent might behave in their self-interest, which could result in a less-than-ideal result for the principal. The principal-agent dilemma is a severe problem in financial markets because investors entrust their money to agents, like fund managers or financial consultants, who make investment decisions for them (Tilton et al. 468).
The principal-agent problem in financial markets develops because investors and agents' interests are only sometimes congruent. While agents may have different goals, such as increasing their fees or commissions, investors may desire to maximize profits while minimizing risks.
Furthermore, agents may possess more knowledge or experience than investors, which could result in a power disparity and opportunism. The case of mutual funds is a typical illustration of the principal-agent problem in the financial markets. Mutual funds are investment vehicles that aggregate investor capital and make various investments. Nonetheless, fund managers or financial advisors who manage mutual funds are paid a fee for their services. The fund manager's goals might not coincide with the investor's, which could result in less-than-ideal results, and thus creates the principal-agent problem.
In bank lending, the bank assumes the agent's role while the borrower is the principal. The borrower always knows more than the lender, resulting in banks rejecting credit to high-risk borrowers or charging excessive interest rates. Employers use pension funds as an investment instrument to offer retirement benefits to their workforce. Financial advisors or fund managers handling pension funds may face a conflict of interest between increasing profits for the pension fund and increasing their fees.
The principal-agent problem can manifest in different ways in financial markets. Adverse selec...