Alternative Business Objectives and the Principal-Agent Problem - Worksheets, Questions and Revision

8 original exam-style questions - 2 pages of questions with a full mark scheme - free printable PDF.

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This topic is chapter 15 of A Level Economics: Microeconomics Practice Book 2.

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1.31 Alternative Business Objectives and the Principal-Agent Problem

AQA 7136 · Calculators not allowed · about 50 minutes

Total Marks

Name: _______________________________ Date: ____ / ____ / ______

Answer all questions. Write full sentences for the scenario question and the extended evaluate question. Timed guidance: about 40 minutes on the short and scenario items, 20 minutes on the essay.

Executive pay and alignment: explain how linking executive pay to firm performance might reduce the principal-agent problem, and give one limitation of pay-based incentives in fully aligning managers with shareholder interests.

(Total for Question 1 is 3 marks)

In the context of UK public limited companies where ownership is often dispersed, evaluate whether shareholders can ever fully control managerial behaviour. In your answer, consider mechanisms shareholders use to influence managers, why these mechanisms may fail or be limited, the role of regulation and markets, and conclude with a supported judgement. Draw on concepts such as the principal-agent problem, agency costs, executive incentives, monitoring, and takeover discipline. You may include brief diagrams or a labelled list to support your analysis, but spend most time on explanation and evaluation.

Evaluate the view that shareholders can fully control managerial behaviour in large public limited companies.

(Total for Question 2 is 15 marks)

Principal-agent problem in a listed UK firm: define the problem and give one typical example of conflicting interests between shareholders and managers.

(Total for Question 3 is 2 marks)

Sales volume maximisation (maximising units sold) as an objective: explain a manager's motive and one likely effect on average cost compared with profit maximisation.

(Total for Question 4 is 2 marks)

Satisficing behaviour by managers: define satisficing in the context of a public limited company and give one reason a manager might satisfice rather than maximise profit.

(Total for Question 5 is 2 marks)

Non-profit objectives: explain why some managers may prioritise firm growth or organisational size even when profits could be higher at a smaller scale, naming one internal incentive that supports this choice.

(Total for Question 6 is 2 marks)

Scenario: A UK supermarket chain, Greenfield Grocers, sets a policy that store managers receive promotion and store-incentive pay based strictly on the number of transactions per month and on market share in each town. Greenfield also deliberately reduces some product prices below competitors to attract customers, accepting thinner margins. Identify which alternative objective Greenfield is most likely pursuing and explain, in one paragraph, whether Greenfield's chosen output level is likely to be above or below the profit-maximising output level. Explain your reasoning.

(Total for Question 7 is 3 marks)

Monitoring and control costs: explain one reason why shareholders cannot perfectly monitor managers in a large multinational company and state one type of cost that results from imperfect monitoring.

(Total for Question 8 is 2 marks)

Mark scheme · 1.31 Alternative Business Objectives and the Principal-Agent Problem

Question 1

M1 explains mechanism: tying pay to performance (share options, bonuses linked to profitability or share price) gives managers a direct financial stake in shareholder outcomes, incentivising decisions that increase shareholder value
A1 develops: use of long-term equity awards can encourage managers to focus on sustainable value creation rather than short-term earnings manipulation
B1 limitation: incentive schemes can encourage short-term manipulation, misreporting, or risky behaviour to hit targets, and may not perfectly align incentives if performance measures are imperfect
Answer: Linking pay to performance incentivises managers to increase shareholder value through bonuses and share-based rewards, but such schemes can encourage short-term manipulation or risky projects and may rely on imperfect performance metrics.

Question 2

Level 1 (1-5): Basic statements about shareholder attempts to control managers with limited development. May describe one or two mechanisms such as monitoring or pay, with little analysis of their effectiveness or limitations.
Level 2 (6-10): Clear explanation of several mechanisms shareholders use to influence managers, such as executive pay, board oversight, shareholder votes and takeover threat, with analysis of how these can align interests and some consideration of agency costs and practical limits.
Level 3 (11-15): A well-developed balanced evaluation that weighs evidence for and against the claim shareholders can fully control managers, discusses why control is often partial (monitoring costs, information asymmetry, short-termism from incentives, collective action problems), considers regulatory and market discipline, and reaches a supported judgement.
Indicative content:
- Mechanisms by which shareholders attempt control: appointing and dismissing boards, AGM votes, executive pay tied to performance, activist shareholders, takeover threat and market for corporate control, disclosure and reporting requirements.
- Ways these mechanisms can succeed: performance-related pay aligns incentives, active monitoring by institutional investors can influence strategy, takeover threat disciplines underperformance, legal/regulatory duties of directors constrain opportunism.
- Limitations and reasons control is incomplete: dispersed ownership causes collective action problems and weak monitoring incentives, information asymmetry leaves managers with informational advantage, monitoring and contracting are costly leading to agency costs, incentives can create perverse outcomes like short-termism or risk-shifting.
- Empirical and practical points: institutional investors vary in activism; regulatory changes can increase transparency but cannot remove asymmetric information; boards may be captured or lack independence.
- Evaluation angles: magnitude and time frame matter, complete control may be infeasible but partial alignment can be achieved; trade-offs between tight control and managerial autonomy for long-term strategy; supported judgement on whether 'fully control' is realistic given costs and governance mechanisms.

Question 3

B1 definition: the principal-agent problem occurs when agents (managers) make decisions that do not fully align with the objectives of principals (shareholders) who hired them
B1 example: managers may prefer to grow the firm and increase their power or perks, even if this reduces short-run shareholder returns
Answer: The principal-agent problem is the conflict when managers act in their own interests rather than shareholders interests; for example managers may pursue empire-building that reduces shareholder returns.

Question 4

B1 reason: managers may aim to maximise units sold to achieve economies of scale, secure market dominance, or meet managers targets based on volume
B1 effect on average cost: output above the profit-maximising level may lower average cost through greater scale, reducing unit costs
Answer: Managers aiming to maximise units sold may do so to gain economies of scale and market share; this often increases output above the profit-maximising level, lowering average cost.

Question 5

B1 definition: satisficing is choosing an outcome that is acceptable or good enough to meet multiple stakeholders objectives rather than the single goal of profit maximisation
B1 reason: managers may satisfice because they value job security, a stable predictable income, and avoiding the risk and effort required to chase maximum profit
Answer: Satisficing is settling for an acceptable level of performance across several objectives rather than maximising profit, often chosen because managers prefer job security and lower risk.

Question 6

B1 reason: growth can increase managers influence, job security and perceived success, and larger firms may offer higher prestige and personal benefits to managers
B1 internal incentive: bonuses or career progression linked to growth or market share rather than to profit alone
Answer: Managers may prioritise growth for greater influence, job security and prestige; internal incentives include bonuses or promotion tied to market share or turnover growth.

Question 7

B1 identifies sales volume maximisation (maximising units or number of transactions) as the objective, supported by incentives tied to transactions and market share
B1 explains direction of output: output is likely to be above the profit-maximising level because managers accept lower prices to increase transactions and market share
B1 links reasoning: lower prices to attract more customers increase quantity sold but reduce per-unit margin, so the firm operates at higher output than the profit-maximising point where MR=MC
Answer: Greenfield is pursuing sales volume maximisation; its output is likely above the profit-maximising level because managers accept lower prices to increase transactions and market share, raising quantity sold while reducing margins.

Question 8

B1 reason: shareholders are numerous and dispersed, often lack detailed firm-specific information and cannot observe day-to-day managerial decisions
B1 cost: leads to agency costs such as expenditure on monitoring, auditing, or lost profit from managers pursuing private benefits rather than shareholder value
Answer: Shareholders cannot perfectly monitor managers because they are dispersed and lack detailed information about daily decisions; this causes agency costs, such as spending on monitoring and auditing or losses from managers pursuing private benefits.

Alternative Business Objectives and the Principal-Agent Problem - Worksheets, Questions and Revision

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1.31 Alternative Business Objectives and the Principal-Agent Problem

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