Principal-Agent Problem

7 Key excerpts on "Principal-Agent Problem"

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  eBook - ePub

  Contract Theory

  Mastering Contracts, Unveiling the Secrets of Economic Exchange

  • Fouad Sabry(Author)
  • 2023(Publication Date)
  • One Billion Knowledgeable

    (Publisher)

  Chapter 11: Principal–agent problem

  The principal–agent problem is the conflict of interests and priorities that arises when one person or organization (the "agent") acts on behalf of another (the "principal") (the "principal").

  This relationship is frequently observed between corporate management (agent) and shareholders (principal), elected officials (agent) and citizens (principal), and brokers (agent) and markets (buyers and sellers, principals). In each of these situations, the principal must consider whether the agent is acting in his or her best interest. Related to the Principal-Agent Problem are the notions of moral hazard and conflict of interest.

  The principal–agent problem typically arises when two parties have different interests and asymmetric information (the agent has more information), such that the principal cannot directly ensure that the agent is always acting in their (the principal's) best interest, especially when activities that are useful to the principal are costly to the agent and when it is costly for the principal to observe certain aspects of what the agent does.

  The agency problem can be exacerbated when an agent represents multiple principals (see multiple principal problem).

  Multiple mechanisms may be employed to align the agent's interests with those of the principal. Employers (principal) can align worker interests with their own through piece rates/commissions, profit sharing, efficiency wages, performance measurement (including financial statements), the agent posting a bond, or the threat of termination of employment.

  The agent is expected to pursue the principal's interests, but when those interests diverge, a dilemma arises. The agent possesses resources that the principal lacks, such as time, knowledge, and expertise. However, the principal does not possess complete control over the agent's ability to act in their best interests. In this scenario, the theory posits that the agent's actions are diverted from pursuing the principal's interests and are instead motivated to maximize their own benefit. In the case of a dual sequence of relationships, for instance, citizens or voters rely on the elected politicians to fulfill their responsibilities by designing a system that ensures their health and financial security. Each citizen is a cog in the machine that is society, and if everyone ignored the operation of each and every entity in the system, society would never advance. However, the minister of health cannot be responsible for overseeing each and every internal operation of each public institution; bureaucrats are in charge of managing these institutions. However, when the seed of corruption is planted, the entire system is disrupted because the agent no longer serves the principal's interests. Beyond economics and institutional studies, the theory now encompasses all contexts of information asymmetry, uncertainty, and risk.

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  Political Economy in Macroeconomics

  • Allan Drazen(Author)
  • 2018(Publication Date)
  • Princeton University Press

    (Publisher)

  C H A P T E R T W O 30 Keeping this constraint in mind, one can say that the principal agent nature of many collective choices does have ramifications for economic outcomes, ramifications which reflect the political nature of decisionmak- ing. First of all, delegation of decisions under imperfect information only has interesting implications if principal and agent do not have identical preferences. If the principal were sure that the agent had exactly the same preferences, there would be no problem of mechanism design. There would be no agency problem. Though this point may seem obvious, it is far from trivial when applied to political economy. The great majority of relationships that define economic life are, in one way or another, agency problems with asymmetric information. The key principal agent relation in political life, between the governed and those who govern them, has been taken in much of public economics to be characterized by an identity of interests between principal and agent. The paradigm is that of a social planner who maximizes the welfare of the representative individual, or of a weighted sum of individuals with different preferences, where the weights are predetermined. Hence, the paradigm of social planner assumes no problem of agency; as argued in the first chapter, the very starting point of political economy is the inapplicability of the paradigm of policy being chosen by a social welfare maximizer. The key fact is heterogeneity of interests that can give rise to agency problems and make the Ž principal agent paradigm relevant. As argued in Chapter 4, in contrast to the usual interpretation, heterogeneity of interests is necessary even for the possibility of a time-inconsistency problem under a ‘‘benevolent’’ social . welfare maximizer. In this sense, economic inefficiencies arising from the principal agent problem are political to the extent that the relevance of the problem is itself political.

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  Accounting for Ministers

  Scandal and Survival in British Government 1945–2007

  • Samuel Berlinski, Torun Dewan, Keith Dowding(Authors)
  • 2012(Publication Date)
  • Cambridge University Press

    (Publisher)

  The basic agency problem is that a principal hires an agent to carry out certain activities on her behalf, but the agent may not carry out those activities effi- ciently or effectively. The problem can emerge because of asymmetric information. For example, the agent knows more about his abilities and proclivities at the time of being hired than does his principal. If such information were common knowledge then the principal might not have hired the agent at all. Moreover, after being hired, the agent can observe more closely what he is doing than can his principal. The former problem is related to the notion of adverse selection. In these situations Gresham’s Law that bad money drives out good is the classic expression of adverse selection. When money was composed of real silver, holders of coins might shave a sliver before exchanging the coin for some goods. Given the positive probability that any coin that one receives might have been shaved, one would not exchange as much in return for it as for a fully unshaved silver coin. Holders of unshaved 8 Managing the cabinet: principal–agent relations coins would then not spend them or would shave them before using them. Bad money drives out good. In modern literature Akerlof (1970) reintroduces adverse selection in his analysis based on used car markets. In his model a car owner knows if his car is good or bad, but the buyer cannot tell. Good cars are worth a high price to both buyer and seller, but buyers do not know if used cars are good or bad so will only pay low prices. Good cars will thus not come on to the market. 1 In agency terms adverse selection generally occurs because those least qualified for a job are those most keen to attain it. For any job at whatever level of remuneration those least qualified are likely to gain the most comparative advantage over their current position and so be keener to attain the position.

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  Trust and Loyalty in Electronic Commerce

  An Agency Theory Perspective

  • Zeinab Karake-Shalhoub(Author)
  • 2002(Publication Date)
  • Praeger

    (Publisher)

  The second is the problem of risk sharing, which occurs when the principal and agent have different attitudes toward risk. Because the principal and agent have different risk preferences, they would prefer different courses of action (Eizenhardt, 1989: 58). Agency models have been developed to examine the relationship that exists when one party (the agent) is engaged to act on behalf of another (the principal). The origin for agency theory is the separation of control and ownership in large corporations. Further, the existence of asymmetric information provides incentives for agents to use their superior information strategically to their personal advantage. Recently, there has been much work on the impact of informational asymmetries on allocation of eco- nomic welfare. In agency theory, it is assumed that both principals and agents are ra- tional, economic individuals who act in their own self-interest. A conflict will occur between agents and principals because of individual self-interest. For example, agents (managers) attempt to maximize their own interests. Consequently, principals (equity holders or debt holders) do not optimize their interests, and "agency costs" are incurred. An agency cost is the re- duction in the owner-manager's utility and/or the cost of the agency rela- tionship between the managers and the outside shareholders or the managers and the debt holders. There are two types of agency costs. The agency costs of equity are the direct costs due to the stockholder-manager conflict. These include perquisite consumption by managers, monitoring and bonding costs from hiring outside monitors, and the cost resulting from non-optimal investment policy. According to the recent agency theory lit- erature, the agency costs of equity are assumed to be a function of mana- gerial ownership, leverage, and dividends. As managerial ownership, leverage, and dividends increase, equity ownership decreases.

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  Public Administration & Public Management

  The Principal-Agent Perspective

  • Jan-Erik Lane(Author)
  • 2006(Publication Date)
  • Routledge

    (Publisher)

  The parameters of principal–agent interaction in the public sector thus involve the utility function of the principal linked with the output of the agent minus the wage of the agent as well as the utility function of the agent linked with the remuneration minus the cost of his/her effort. Thus, the principal wants to maximise the value of the output minus the costs involved in paying the agent for his/her work, whereas the agent wishes to maximise his/her salary minus the cost of effort. What are the outcomes of this interaction? One may model the relationship between government and a bureau or public enterprise as principal–agent games. One may also model the relationship between the manager and his/her employees within a bureau or public enterprise as such a principal–agent game. We will distinguish between these two games – government–bureau (enterprise) and manager–employee – in the subsequent chapters.

  Solving for principal–agent interaction one may assume either complete knowledge or incomplete knowledge. Typical of the principal–agent interaction in the public sector is that the value of the work of the agent is not measurable in money or at market value. However, the principal must pay the agent and thus he/she incurs costs. Can the principal write and enforce a contract that elicits high effort? The agent will not work for free, only participating if his/her utility is at least at some minimum level (reservation price), and he/she will not produce high effort unless rewarded for that (incentive compatibility). Given perfect information about the contract and its enforcement, there is a set of first-best contracts that would secure an efficient solution. The outcome would basically depend upon the availability of agents, meaning that the more abundant the agents are, the higher the gain of the principal in the sense of low salary costs.

  However, due to the ambiguity of public sector contracting the agent could choose a contract with high reward, but supply low effort. There may occur suboptimisation due to the behaviour of the agent, who in a sense reneges on the contract. One may also conceive of the possibility that the principal reneges. The basic problem is the occurrence of contractual incompleteness. Thus, we have a game where the principal has a dominating strategy – low pay – and the agent has similarly a dominating strategy – low effort. The logic of incentives in public sector agency according to this representation is thus that an optimal contract is not feasible when there is contractual incompleteness due to unforeseen events or a lack of enforceability of contracts. Ambiguity or incompleteness results in incomplete knowledge, of which asymmetric knowledge is one kind. Two types of asymmetric knowledge have been much discussed in the principal–agent literature, namely adverse selection and moral hazard.

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  A Handbook of Management Theories and Models for Office Environments and Services

  • Rianne Appel-Meulenbroek, Vitalija Danivska, Rianne Appel-Meulenbroek, Vitalija Danivska(Authors)
  • 2021(Publication Date)
  • Routledge

    (Publisher)

  10 Principal-agent theory

  Perspectives and practices for effective workplace solutions

  Torben Bernhold* and Niklas Wiesweg

  * Corresponding author: [email protected]

  DOI: 10.1201/9781003128786-10

  1 Background

  In recent years, principal-agent theory has found extensive development and use in the field of scientific research methodology, for example in accounting, marketing, economics, political science or organizational behaviour (Eisenhardt, 1989). The fundamental question of the justification for the existence of companies goes back to Coase (1937) and is regarded as the basis and foundation of the New Institutional Economics, which deals with the economic analysis of the institutional environment and institutional arrangements (Williamson, 1991). The three main domains of transaction cost theory, principal-agent theory and property rights theory form a bundle of what is generally understood under the term New Institutional Economics (Irmer, 2001; Picot et al., 1999).

  Principal-agent theory is an approach closely related to transaction cost theory. While transaction cost theory attempts to explain the economic advantageousness of forms of cooperation on the basis of transaction costs, principal-agent theory treats the examined service relationships as a client-contractor relationship (Cheon et al., 1995; Ebers & Gotsch, 2006; Picot et al., 1999). The main objective of principal-agent theory is to design contractual relationships between the principal and the agent as optimally as possible. However, the underlying assumptions need to be considered, including: (1) actors behave as benefit maximizer (Eisenhardt, 1989; Lassar & Kerr, 1996), (2) conflicting interests exist ( Jensen & Meckling, 1976), (3) actors have only limited rationality (Eisenhardt, 1989; Picot et al., 1999) and (4) information asymmetries exist between principal and agent (Picot et al., 1999; Richter & Bindseil, 1995; Ross, 1973; Voigt, 2002). These information asymmetries allow the actors to use the discretionary scope for behaviours that maximize their own benefit. In order to counteract this, the principal intends to influence the agent’s behaviour by suitable incentive agreements or incentive systems. The agency problems formulated within the principal-agent theory take the form of ‘hidden characteristics’, ‘hidden action’ and ‘hidden information’ as well as in the most challenging variant of ‘hidden intention’.

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  The Principal Agent Model and the European Union

  • Tom Delreux, Johan Adriaensen, Tom Delreux, Johan Adriaensen(Authors)
  • 2017(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The main motivations for delegation are the reduction of transaction costs in policy-making or the signalling of a credible commitment to the relevant stakeholders (Epstein and O’Halloran 1999 ; Majone 2001 ; Pollack 2003). Delegation occurs because principals find it beneficial that agents execute functions on their behalf. These functions are extremely diverse and range from monitoring compliance and thereby addressing collective action problems; solving problems of incomplete contract ing; providing technical and independent expertise; being blamed for unpopular decisions; and reducing instability by locking in political agreements and setting the agenda (Garret 1992 ; Pollack 1997 ; Kassim and Menon 2003). A key aspect of the principal–agent model is that delegation not only implies benefits for the principal, but also agency costs. Yet the benefits initially always outweigh the costs since otherwise delegation would not occur. The costs of delegation relate to the fact that there is a real possibility that the agent will act opportunistically and behave contrary to what the principal wants. If that occurs, it is called “agency slack” or “agency loss”. The costs of delegation are caused by preference divergences and information asymmetry between principal and agent. On the one hand, an agent may have—and try to realize—his proper preferences, which can differ from those of the principal. 2 On the other hand, the agent can be better informed than the principal and use that private information at the principal’s expense. Briefly, the decision to delegate immediately implies a risk of heterogeneous preferences and a risk of asymmetrical information, which can be counterproductive for the principal

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