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The Principal Agent Problem and Market Concentration

Market Concentration

Concentration can be measured using the concentration ratio which measures the market share of large firms in an industry. It is usually measured as the concentration of n-firms in the industry. For example the 3-firm concentration ratio shows the concentration ratio that the largest 3 firms in a market possess, this can be calculated as the sum of their individual market shares. It can also be reflected in terms of employment, by the proportion of workers in any industry that are employed in the largest firms. If a market is highly concentrated then there is fewer firms operating in this market. Conversely if a market is less concentrated then there are more firms within the same market.

An evaluative point to the use of the concentration ratio is that there may be problems defining the market. If a competition watchdog used the ratio to measure whether or not a firm is defined as a monopoly (if the ratio produces a result greater than 25%) how does it decide the width and depth of the market? For example when trying to identify the market that Facebook lies in, would the watchdog includes photo-sharing websites (as Facebook owns Instagram), does it also include phone apps. Calculating the size of the market may not be as simple as it first seems!

Also concentration ratios may provide a misleading result. If we are told that the 5-firm concentration ratio is 90%, this may mean that one firm has 80% of the market and the other 4 firms have the remaining 10% share. This is a worse situation (due to monopoly reasons) than if all firms had an 18% share each. Therefore we can’t come to a conclusion on the market situation based solely on the results of the concentration ratio without more information.

The Principal Agent Problem

The principal agent problem exists as conflicting interests between the intentions of the principals (owners) and the agents who make the decisions on behalf of the principals. In the context of a firm it is the conflicting interests of the shareholders (principals) and the chief executive and other managers (agents) who run the day-to-day business of the firm.

If the agents directly benefit from the objectives of the principals then no problem arises as the managers take the decisions that the shareholders want them to. However this isn’t always the case as the agents may benefit from different policies than the principals want; this could be to the detriment of the principals.
Herbert Simon believed that managers want a quiet/easy life and so would undertake satisficing behaviour where managers produce enough profits to keep shareholders happy, but this may not actually be maximum profits.

Managers may also maximise other aspects of the firm, for example revenue as their wage may be linked to revenue. This goes against the wishes of the shareholders who always want the firm to profit maximise so they can receive a large dividend. Managers may also not be fully accountable and this could lead to organisational slack.

Page last updated on 20/10/13