CFA Practice Question
Which of the following is correct?
A. In a situation where the Principal Agent Problem exists, a rational Principal would write a contract in which the payoff to the Agent considers only Agent's actions and not the outcome of those actions.
B. The Principal Agent Problem arises because some actions of the Agent are not observable by the Principal.
C. The use of a public park without sharing in the cost of the park is an example of a Principal Agent problem.
Explanation: As outcomes rather than actions are observable, a rational Principal would write a contract in which the payoff to the Agent considers outcome of the Agent's actions. The idea is to motivate the Agent to take those actions beneficial for the Principal (even though the actions are not observable) as the actions partly determine the outcomes. The public park example is a Free Rider problem, rather than a Principal Agent problem.
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