Sizes and types of firms — Edexcel A-Level Economics A
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Sizes and types of firms explained
The divorce of ownership from control occurs when shareholders own a company but directors and managers control day-to-day decisions.
Read the full explanation
This creates a principal-agent problem: the agent may pursue objectives such as higher salary, status or sales growth rather than shareholder aims like profit maximisation. For example, managers might expand the firm through acquisitions to increase their own prestige, even if this reduces profit. The significance is that firms may not maximise profit, monitoring costs rise, and shareholders use incentives or performance-related pay to align interests. MCQ questions test understanding of who is principal, who is agent, and the resulting conflict.
Your focus
- Define the divorce of ownership from control and identify the principal and agent.
- Explain how the principal-agent problem can lead to objectives other than profit maximisation.
- Evaluate the significance of the principal-agent problem for shareholders and firm behaviour.
Sizes and types of firms exam tips
Marking Points
- Ownership rests with shareholders, while control rests with directors and managers.
- The principal-agent problem arises because the agent's objectives may differ from the principal's objectives.
- Managers may pursue sales maximisation, revenue growth or personal prestige instead of profit maximisation.
- Shareholders may incur monitoring costs and use incentives such as share options to align interests.
- The result can be a firm that does not maximise profit, affecting dividends and share price.
Examiner Tips
- 💡Identify the principal and agent in the scenario before evaluating the options.
- 💡Look for options that describe a conflict of objectives, not just a separation of roles.
- 💡Eliminate options that describe outcomes unrelated to ownership and control, such as technological change.
Common Mistakes
- Reversing the roles: correction — shareholders are the principals and managers are the agents.
- Assuming managers always maximise profit: correction — managers may prioritise their own utility, such as higher pay or status.
- Ignoring the cost of monitoring: correction — shareholders may spend on monitoring and incentives, which reduces net returns.
- Confusing the principal-agent problem with economies of scale: correction — the principal-agent problem is about conflicting objectives, not cost advantages.