What is Utility Theory?

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Microeconomics vs Macroeconomics - What's the Difference?

What is the Austrian School of Economics?| Definition & Analysis

Before introducing the Austrian School of Economics, it is important to define what a school of economics is. Intuitively, one would think it is an academic institution that develops and promotes a specific economic ideology. Even though this can be the case, a school of economics also refers to a group of economic thinkers who share a common perspective. Not all economists who belong to a school of economics have studied or developed their ideas under the same academic institution, but they share the same “school of thought.” Therefore, when economists refer to a “school of economics” they are interchangeably referring to an economic ideology or wave of economic thinking. 

With this caveat in mind, the Austrian School of Economics was founded by Austrian economist Carl Menger in 1871. Menger studied economics at the University of Prague and Vienna from 1859 to 1863 and officially baptised the Austrian School with the publication of his book Principles of Economics (1871). Renowned economists who shared his thinking include Joseph Schumpeter, Friedrich Hayek, and Ludwig von Mises. In essence, the Austrian School advocated that economics cannot be mathematically and statistically modeled. One size doesn’t fit all, because individuals have subjective preferences and make subjective choices which cannot be accounted for in a single economic model. 

Austrian School thinkers supported free markets with less government control to reflect the subjectivity and freedom of individuals’ thinking. Lawrence Moss briefly summarises and defines the essence of the Austrian School of Economics here: 

Modern Applications of Austrian Thought

The Austrian school is a “humbling school”, one that cautions other economists not to pretend that they can make marvelous forecasts about future market conditions. Austrians have most consistently ridiculed the pretensions of statistical economists and econometricians who, whether for private gain or for media reputation, declare that they can estimate some specific market rate, such as short-term interest rates, with enough accuracy to guide business decision-making or (in some circumstances) orchestrate national economic planning. ("The applied economics of the modern Austrian school," Modern Applications of Austrian Thought, 2007)

This school of economic thought has evolved, died, and re-emerged over time. In Austrian Economics (2020), Steven Horwitz guides us through the school’s varying fortunes: 

Austrian Economics

The Austrian School dates back to the revolution in economic thinking of the 1870s that created the modern approach to economics. At the turn of the 20th century, and for the next few decades, the Austrian School was one of the dominant schools of thought in economics. Its influence was diminished in the 1930s by two developments. First, the Keynesian revolution in macroeconomics that emerged out of the Great Depression pushed Austrian ideas aside. Around the same time, microeconomics was becoming increasingly expressed in formal mathematical terms, with economic problems being seen as special types of engineering problems. Both of these changes in the way economics was done were at odds with the Austrian approach. As a result, the Austrian School all but disappeared from around World War II until the early 1970s.

What are the characteristics of the Austrian School of Economics? 

Every wave and school of economic thinking has a unique standpoint on all microeconomic and macroeconomic questions, and it is therefore difficult to summarise them all in one guide. However, there are three particularly noteworthy and innovative outcomes from the Austrian School of Economics that should be remembered. Economic thinkers of the Austrian School developed a unique approach when it came to thinking about the subjective nature of value and utility, their perspectives on time in the context of economic affairs, and the role of competition and entrepreneurship in business cycles. We will explore each of these three areas below.

The question of value and utility has been explored extensively by economists of all ideologies over centuries. How do people assign a value to the goods they consume? What is the utility (i.e., satisfaction) that they extract from its consumption? 

Carl Menger initiated the Austrian School of Economics by revolutionising utility theory with his contributions. He was one of the first economists to confidently say that utility, value and preferences were highly subjective, and not as easily measurable as economists like William Jevons or Léon Walras had previously suggested. Indeed, while Jevons and Walras measured utility in total terms using a hypothetical metric for satisfaction known as a “util,” Menger introduced the concept of marginal utility. His reasoning on the measurability of utility brought in the subjective nature of value and preferences that he argued for. This is explained by Randall G. Holcombe in Advanced Introduction to the Austrian School of Economics (2020):

Advanced Introduction to the Austrian School of Economics

One of the observations that Carl Menger [...] made in his Principles of Economics is that if people increase the quantity they consume of a good or service, the additional units they consume will be used to satisfy less urgent desires, and those less urgent uses will have a lower subjective value to the consumer. Water provides a good example. The first few cups of water an individual consumes every day are very valuable, and indeed, life-sustaining. People who live in places where water is costly to obtain [...] pay a lot to get it and have an incentive to conserve it. [...] If water is very inexpensive, they might use it to water houseplants, or to wash their dog or their car. These uses that have a lower subjective value do not reduce the value of the water they drink to sustain their lives, however. The first few units of water consumed will have a high subjective value, and if more is available, consumers will use them for uses that have increasingly less subjective value.

Even though this might seem obvious and logical to us now, Menger’s approach was groundbreaking and caused controversy in the study of economics at the time.

Menger started the trend of thinking of economics in a more fluid way, shying away from the rigidity of mathematical models and frameworks that didn’t account for human non-linearity. Indeed, economists of the Austrian School of Economics were more granular in exploring human factors and other external factors that made those long-standing models imperfect. One of those external elements was time. As Ivan Moscati explains in From Classical Political Economy to Behavioral Economics (2013), Austrian School economists believed in the intertemporal dimension of economic activity: 

From Classical Political Economy to Behavioral Economics

In Austria, Menger’s analysis was extended by Eugen von Böhm-Bawerk, Friedrich von Wieser, and other members of the Austrian School. The Austrians insisted on the subjective nature of value and stressed the intertemporal dimension of economic activity. For them, current production costs are ultimately determined by the future utility of consumption goods; moreover, since production takes time, current investment decisions depend on expectations about the future value of consumer goods.

The Austrian School believed that the past and future of economic activity should be accounted for in order to make accurate statements about the economy. However, introducing this intertemporal element into economic models meant that more abstract and unmeasurable variables such as expectations and uncertainty were brought into the picture. Ultimately, as Holcombe argues, failing to account for the past, present and future of economic scenarios “obscures the significance of time”:  

Economic processes occur over time. An equilibrium framework for analysing economic phenomena tends to obscure the significance of time, because in that framework it appears that the conditions that define an equilibrium remain given and unchanging, and the role of the market process is to pull the economy toward that equilibrium. In fact, economic conditions are constantly changing, partly as a result of the decisions continually being made by other economic actors who are deciding their courses of action based on necessarily imperfect information. Future conditions depend on decisions people are in the process of making in the present. Their choices determine the future trajectory of the economy. (2020)

Competition, entrepreneurship and business cycles 

So how did the Austrian School integrate the element of time into their economic thinking to solve for the imperfection of existing models? They believed that economic situations should be looked at on a case-by-case basis. Economic success would be dictated by humans’ ability to coordinate the right resources in the right amounts at any given time. Austrian School economists argued that intervention by institutions such as the central bank impeded these natural “coordination” processes, and therefore advocated for a non-interventionist approach where markets would correct themselves.

Austrian School economists such as Israel M. Kirzner believed that competition and entrepreneurship would foster and catalyze coordination in economies, bringing them to success at different times and in different scenarios. In Competition and Entrepreneurship, Kirzner explains that entrepreneurship and competition are highly valuable because they act as the engine of economic progress — identifying and exploiting new opportunities: 

Competition and Entrepreneurship

In a market economy at any given time, an enormous amount of ignorance stands in the way of the complete coordination of the actions and decisions of the many market participants. Innumerable opportunities for mutually beneficial exchange (including production as an avenue for exchange) are likely to exist unperceived. Each of these opportunities also offers an opportunity for entrepreneurial profit. Each of the potential parties to each of these unexploited exchange opportunities is, as a result of the imperfection of knowledge, losing some possible benefit through the absence of coordination represented by this situation. The normative question raised by Hayek is how well the market succeeds in bringing together those uncoordinated bits of information scattered throughout the economy. Successful coordination of these bits of information cannot fail to produce coordinated activity—exchange—benefiting both parties. (1973, [2015])

How does it differ from other schools of economic thought? 

Over the years, different schools of economics have formed, each with its own set of ideas and principles that shape its identity. Distinguishing between a school of economic thought and an economic ideology can be tricky, as the distinction is subtle. However, apart from the Austrian School, three other significant schools exist: the Cambridge, Lausanne, and Chicago schools of economics. 

Economist Alfred Marshall founded the Cambridge School of Economics in the 1890s with the publication of Principles of Economics (1890). This became the dominant economics textbook in England at the time, with significant contributions on supply and demand, partial equilibrium and marginal utility. In The Economics of Alfred Marshall, David Reisman aims to explain and simplify Marshall's complex ideas. In the introduction, he acknowledges that Marshall's work is detailed and extensive, reflecting his role as a creative thinker: 

The Economics of Alfred Marshall

If the economics of Alfred Marshall is at times tentative and impressionistic, it is because Marshall was in every respect the genuinely radial thinker, at all times conscious of a million possibilities — and of the essential complexity of human action. (1986, [2013])

The Cambridge School promoted and believed in the ideas of Keynesian economics. Indeed, the Cambridge School is often referred to as "the Keynesian School of Economics" due to the close relationship between Alfred Marshall, its prominent figure, and the economist John Maynard Keynes, who was a student of Marshall (resulting in a mutual influence on each other's ideas). The Cambridge School mainly differed from the Austrian one in its methodology and policy perspectives. The Austrian School promoted deductive reasoning and avoided the use of mathematics to model economics, while the Cambridge School employed empirical analysis to reach its theoretical conclusions. In terms of policy perspectives, the Austrian School believed in laissez-faire, non-interventionist policies and highlighted the role of entrepreneurship in coordinating economic activity, while the Cambridge School advocated for government intervention to correct market failures. 

French economists Léon Walras and Wilfredo Pareto are thought to have founded the Lausanne School of Economics in the late 19th century. The most notable difference between the Lausanne and Austrian Schools is the approach and methodology they followed to solve economic questions. Lausanne economists advocated the use of mathematics in the study of economics. What is more, the school and its member economists invented a novel sub-branch of economics known as “mathematics economics.” Margaretta Foy defines the discipline as follows: 

Mathematical Economics

Mathematical economics is the application of mathematical methods to represent economic theories and analyze problems posed in economics. It allows formulation and derivation of key relationships in a theory with clarity, generality, rigor, and simplicity. By convention, the methods refer to those beyond simple geometry, such as differential and integral calculus, difference and differential equations, matrix algebra, and mathematical programming. (Mathematical Economics, 2014)

The Austrian School methodology was the opposite — they believed in using logic to think through economic problems without relying on mathematics to do so. However, Lausanne School economists were aware that using mathematics to understand economics had its limitations, and they pioneered utility theory by thinking of it in ordinal terms, as opposed to cardinal terms. In other words, they recognised the challenge of measuring utility and proposed that one could only compare, rank, and order the utility gained from various goods and services based on individual preferences.

Founded in the 1930s, the Chicago School of Economics has been one of the most influential and popular schools of economics since the end of World War II. As Warren J. Samuels argues in The Chicago School of Political Economy (2021), 

The Chicago School of Political Economy

Whether the success of the School is due to the merit of its ideas, the hard work and/or personality of its members, or the spirit of the age, or some combination of these, the School is arguably the most successful in economics since World War Two. The story that the Chicago School tells performs several specific functions. It attempts to describe, explain, and understand the economy. [...] It attempts to provide a psychic balm by which people can accept the market economy and its results without serious question, thus countering the, shall we say, natural tendency of people and groups to seek government solutions for common problems. And it attempts to legitimize economics as the putative queen of the social sciences, that is, to further enhance the status of economists and the social role of economists as persons of expert knowledge.

Economists of the Chicago and Austrian schools share many similarities in their way of thinking. For example, they both favor policies that avoid government interference, and they rely on logical reasoning to comprehend economic phenomena. However, Chicago thinkers combine reasoning with empirical evidence and show significant differences in some points of economic theory compared to Austrian School economists. For instance, Chicago School economists and Austrian School economists often have contrasting perspectives on government intervention in interest rates. The Austrian School typically regards such manipulation as fundamentally problematic, whereas the Chicago School tends not to share this view.

Overall, the Austrian School viewed economics as a social science more than a mathematical discipline. Introducing the element of time, the subjective nature of value and preferences, and the essential role of competition and entrepreneurship sets it aside from other schools of economic thought including the Lausanne, Cambridge, and Chicago schools of economics. While the approaches and theories developed in each of these schools differ, there is no right or wrong answer here. Economics is a dynamic and evolving field, shaped by diverse perspectives and ongoing debate.

Carl Menger And The Origins Of Austrian Economics (2019) by Max Alter

Individualism and Economic Order (1948, [2012]) by F. A. Hayek

Austrian Economics Re-Examined: The Economics of Time and Ignorance (1985, [2014]) by Gerald P. O'Driscoll, Jr. and Mario Rizzo

Foy, M. (2014) Mathematical Economics. World Technologies. Available at: https://www.perlego.com/book/1239853/mathematical-economics-pdf 

Holcombe, R. G. (2020) Advanced Introduction to the Austrian School of Economics. Edward Elgar Publishing. Available at: https://www.perlego.com/book/3546457/advanced-introduction-to-the-austrian-school-of-economics-pdf 

Horwitz, S. (2020) Austrian Economics: An Introduction. Cato Institute. Available at: https://www.perlego.com/book/1600640/austrian-economics-an-introduction-pdf 

Kirzner, I. (2015) Competition and Entrepreneurship. The University of Chicago Press. Available at: https://www.perlego.com/book/1851137/competition-and-entrepreneurship-pdf 

Marshall, A. (2013) Principles of Economics. Palgrave Macmillan UK. Available at: https://www.perlego.com/book/3490031/principles-of-economics-pdf 

Menger, C. (2007) Principles of Economics. The Ludwig von Mises Institute. Available at: https://mises.org/library/principles-economics 

Moscati, I. (2013) From Classical Political Economy to Behavioral Economics. Egea. Available at: https://www.perlego.com/book/4328773/from-classical-political-economy-to-behavioral-economics-pdf 

Moss, L. S. "The applied economics of the modern Austrian school," in Backhaus, J. G. (ed.) Modern Applications of Austrian Thought. Taylor and Francis. Available at: https://www.perlego.com/book/715359/modern-applications-of-austrian-thought-pdf 

Reisman, D. (2013) The Economics of Alfred Marshall (Routledge Revivals). Taylor and Francis. Available at: https://www.perlego.com/book/1674873/the-economics-of-alfred-marshall-routledge-revivals-pdf 

Samuels, W. (2021) The Chicago School of Political Economy. Taylor and Francis. Available at: https://www.perlego.com/book/3078213/the-chicago-school-of-political-economy-pdf 

For more about other schools of economics over time, you can read “Schools Of Economic Thought: Encyclopedia, Science News & Research Reviews”

What is the Austrian School of Economics?

What is The Law of Diminishing Returns?

What is Auction Theory?

What is Marxism?

What is the AD-AS Model?

What is Capitalism?

What is Globalization?

What is New Growth Theory?

What is the Law of Supply and Demand?

What is the Principal-Agent Problem?

Game Theory | Definition, Examples & Analysis

Our daily lives are made up of interactions with different people, agents and institutions. These interactions can range from cooperation to conflict. For instance, with friends, you will cooperatively exchange ideas to decide on the plans for the weekend based on everyone’s preferences. At the workplace, companies will look at what competitors are doing to decide what their next move in the market will be. The beauty of humanity is that we are all interrelated, and the decisions of one actor will influence and be influenced by the decisions of others. Game theory allows us to understand how people act in situations where they are interconnected. It does so by treating individuals as players in a game, assuming that every player is rational (i.e., makes decisions in pursuit of their own objectives) and intelligent. As described by the theorist and Nobel Prize winner Roger B. Myerson in his book Game Theory: Analysis of Conflict, game theory situations are best represented using mathematical models.

Game Theory: Analysis of Conflict

Game theory is the study of mathematical models of conflict and cooperation between intelligent rational decision-makers. (2013)

Most of the early developments of game theory happened at the University of Princeton in the early 1920’s. It was John Von Neumann, the renowned Hungarian-American mathematician, who first explored this science of strategy known as game theory. The culmination of his findings were condensed in the book Theory of Games and Economic Behaviour, which he published in 1944 and co-wrote with his fellow colleague and economist Oskar Morgenstern. In the book, they argued that any economic situation could be looked at as a game between two competing actors. 

Theory of Games and Economic Behavior

The next stage develops when the theory is to somewhat more complicated situations in which it may already lead to a certain extent beyond the obvious and the familiar. Here theory and application corroborate each other mutually. Beyond this lies the field of real success: genuine prediction by theory. It is well known that all mathematized sciences have gone through these successive phases of evolution. (2015)

Their conclusions rapidly drew the attention of economists and politicians of the time, who found extreme value and relevance in the applications of game theory to warfare matters during WWII and the beginning of the Cold War. More specifically, game theory soon became the theoretical foundation for war analysts and politicians to locate enemy submarines. A strategy was desperately needed to ensure torpedoes were fired where enemy warships were located. For that, it was necessary to act based on what the enemy was doing and game theory could provide the answers. 

John Nash, a mathematics graduate at the University of Princeton soon became the next groundbreaking theorist to unlock a whole new outlook for game theory. In the early 1950’s he came up with a way of solving non-cooperative games (ie., where players act independently) such that all players win because everyone gets the outcome they desire. As explained in the book The Essential John Nash, this outcome of mutual player contentment is known as the Nash equilibrium. It is the combination or set of player moves such that no player finds any additional benefit in choosing a different strategy; all players are satisfied with their game choices at the same time, so the game remains at equilibrium.

Nash equilibrium - a configuration of strategies, such that no player acting on his own can change his strategy to achieve a better outcome for himself.

The Nash equilibrium marked a turning point for game theory. John Nash had found a simple and highly applicable way of solving problems in all kinds of contexts. His disruptive discovery gained respect and notoriety, resulting in best-selling books (and later film adaptation) “A Beautiful Mind”.

But the bizarre and elaborate character of Nash’s beliefs, which were simultaneously grandiose and persecutory, his tense, suspicious, guarded behaviour, the relative coherence of his speech, the blankness of his facial expressions, and the extreme detachment of his voice, the reserve which bordered at times on muteness — all pointed toward schizophrenia.

Even though Nash’s theory received a lot of praise and admiration, some “hated” his findings. Indeed, Von Neumann, the founding father of game theory, was against a single-point solution. Other theorists remained open-minded to Nash’s discoveries and decided to address the loopholes of game theory to the date, refining and improving the generalisability of Nash’s theory. In the 1960’s, economists Thomas Schelling, Reinhard Selten and John Harsanyi addressed issues in games with multiple Nash equilibria, or where players could not communicate or had incomplete information. In 1994, Nash, Shelling and Hirsanyi won the Nobel Prize for their pioneering analysis of game theory in non-cooperative games. 

The Prisoner's Dilemma came about in the RAND Corporation (department of Research and Development of the US Air Force) in 1950. It is a game or strategic interaction which has been widely used to illustrate and exemplify the workings of game theory. 

The book Game Theory: An Introduction by 50Minutes.com briefly explains the essence of this dilemma: 

Game Theory: The art of thinking strategically

Two thieves are arrested by the police and interrogated separately. The police are convinced they are guilty, but do not yet have sufficient evidence to heavily sentence them. Between them, before the arrest, the thieves vowed not to betray one another. The police, who want more than anything to get the confessions of the two men, promise freedom to the person that speaks, if he is the only man to do so. Hence a dilemma arises: on the one hand, the prisoners know that they will only suffer a small penalty if they do not confess to the police. On the other hand, both are individually tempted to confess the crime to gain freedom. (2016)

The two players can choose between two strategies: “deny” or “confess”. Depending on what they choose, they will spend more or less years in prison. In the matrix, the payoffs (i.e, the years that they spend in prison) are the numbers in each of the boxes. The first digit corresponds to the years spent in prison by Player 1 and the second, those spent in prison by Player 2. For example, if Player 1 confesses and Player 2 denies, they will spend 0 and 5 years in prison respectively. 

The objective of both players is to minimise the time spent in prison. To find the Nash equilibrium, you ask yourself “If Player 1 denies, what is the best thing Player 2 can do?”. In this case, Player 2 is better off confessing since he would spend 0 years in prison given that Player 1 denied. Following this procedure for all possible actions and for both players will yield the Nash equilibrium, the strategy where no player will want to dive. To see the full working out of the procedure, you can follow this link to a one page infographic. In this case, the Nash equilibrium occurs when both Players confess. 

What are some uses of Game Theory in real life?

Being in a situation similar to the prisoner’s dilemma is not uncommon. This becomes obvious in the book Introducing Game Theory, which illustrates game theory’s applications in a wide range of contexts. 

Introducing Game Theory: A Graphic Guide

In economics, the decisions of firms are affected by their expectations of a competitor’s choice of product, price and advertising. In political science, a candidate’s policy platform is influenced by the policy announcements of their rival. In biology, animals must compete for scarce resources, but can be hurt if they are too aggressive with the wrong rival. In computer science, networked computers compete for bandwidth. In sociology, public displays of non-conformist attitudes are influenced by others’ behaviour, which is shaped by social culture. (2017)

Indeed, the applications of game theory are infinite ranging from economics, politics, biology, computer science or sociology to name a few. Most commonly, the strategy departments of businesses will use game theory to understand how to react to competitor actions. For example, say there are two main competing firms in an industry: Firm A and Firm B. Recently, Firm A has been reconsidering their pricing strategy, looking at whether they should increase or decrease their prices to boost their revenues. Firm B intends to use game theory to understand what their best response to Firm A’s pricing strategy will be. This example can be solved just like the prisoner's dilemma.  Both companies can choose between two strategies: increase or decrease their market price. Their payoffs are the revenue gains or losses generated from  their chosen pricing strategy. Firm B will find the Nash equilibrium to decide what their optimal response strategy will be. 

What are some limitations of game theory in real life?

Born in the 1920’s, game theory is a relatively young field of study which has received weighty academic attention for over a century. In a way, this discipline empowers individuals to predict the unpredictability of human behaviour. However, any science, mathematical or theoretical model will have its own limitations which will constrain its generalisability to all scenarios. 

In the opening of the article, game theory is defined under the assumption that all humans are rational. That is, game theory assumes that individuals will make the choices that benefit them the most. However, as explained in the book Introducing Game Theory, people will not always have the desire of maximising their utility when making a decision. Think of NGOs or kidney donors; they will not always make the choice that is most rational or beneficial to themselves. 

The concept of rationality requires unlimited cognitive capabilities. Fully rational man knows the solutions of all mathematical problems and can immediately perform all computations, regardless of how difficult they are.

Along with the unrealistic assumption of human rationality, the incompleteness of information in strategic scenarios has been another main criticism around game theory from its early beginnings.  Indeed, game theory assumes that players know their payoffs under different strategies. In reality, outcomes are just as unpredictable as human behaviour itself. 

These small details and assumptions may condition the accuracy of game theory. Therefore, it is important to be mindful of the fine line between hypothesising the outcome of strategic behaviours versus making blunt conclusions and statements on future human behaviour. 

To conclude, the study of game theory is undoubtedly one of the most complex and ambitious fields of microeconomics. It is complex because there are a plethora of potential situations and strategic interactions that can happen in real life that game theory must find answers to. Attempting to put a mathematical framework around this complexity and the unpredictability of human behaviour makes game theory an ambitious and beautiful science.

To read more about the applications of game theory to climate change, Game Theory and Climate Change by Parkash Chander

To read more about the applications of game theory to political science, Game Theory for Political Scientists by James D. Morrow

To read more about the applications of game theory to sports and soccer, Beautiful Game Theory by Ignacio Palacios Huerta

To read more about the applications of game theory in business management, Game Theory in Management by Michael Hatfield

Myerson, R. (2013) Game Theory. Harvard University Press. Available at: https://www.perlego.com/book/1147792/game-theory-analysis-of-conflict-pdf  (Accessed: 14 February 2023).

Universalis, E. (2015) Theory of Games and Economic Behavior de Christian Morgenstern. Encyclopaedia Universalis. Available at: https://www.perlego.com/book/3571154/theory-of-games-and-economic-behavior-de-christian-morgenstern-les-fiches-de-lecture-duniversalis-pdf  (Accessed: 14 February 2023).

 Nash, J. (2016) The Essential John Nash. Princeton University Press. Available at: https://www.perlego.com/book/737869/the-essential-john-nash-pdf  (Accessed: 14 February 2023).

Nasar, S. (2011) A Beautiful Mind. Simon &#38; Schuster. Available at: https://www.perlego.com/book/779628/a-beautiful-mind-pdf  (Accessed: 14 February 2023).

50MINUTES.com (2016) Game Theory. 50Minutes.com. Available at: https://www.perlego.com/book/9331/game-theory-the-art-of-thinking-strategically-pdf  (Accessed: 14 February 2023).

Pastine, I., Pastine, T. and Humberstone, T. (2017) Introducing Game Theory. Icon Books. Available at: https://www.perlego.com/book/569883/introducing-game-theory-a-graphic-guide-pdf  (Accessed: 14 February 2023).

What is Game Theory?

What is the Multiplier Effect?

What is Market Competition?

What is the Labor Theory of Value?

What is the Principal-Agent Problem? | Definition, Examples & Analysis

In economics, the principal-agent problem occurs when a principal (i.e., the owner of a resource) delegates a task, service or decision to an agent and a conflict or misalignment of interests arises between both parties. Assuming that both the principal and agent are utility maximizers, this misalignment will lead to either of them acting in their own self-interest. A solution to the problem must be found, so that both parties can harmoniously behave in their mutual best interests.

In 1976, economists Michael C. Jensen and William H. Meckling created the most influential formulation of the principal-agent problem in their paper “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” In economics, this problem falls under the study of agency theory, which is often thought to be part of broader branches of microeconomics such as game theory and incentive design. Michael C. Jensen reprinted the findings of his paper in A Theory of the Firm (2003), where he explains the foundations and principles of the principal-agent problem: 

A Theory of the Firm

We define an agency relationship as a contract under which one or more persons—the principal(s)—engage another person—the agent—to perform some service on their behalf that involves delegating some decision-making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergences from her interest by establishing appropriate incentives for the agent in the contracts they create and by incurring monitoring costs designed to limit the aberrant activities of the agent. In addition, in some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions that would harm the principal or to ensure that the principal will be compensated if he does take such actions. 

Causes and consequences of the principal-agent problem

It is helpful to use an example to bring the principal-agent problem to life, and understand its causes and consequences. The most commonly used example in agency theory literature happens within firms and organizations across the globe. In Operational Risk Management (2021), Jasmijn Bol and Jenna M. Blanche present a clear example of a principal-agent problem where the principal is the shareholder or group of shareholders who own the firm (e.g., through the acquisition of stocks). The agent here, is the CEO or the members of the executive board who make strategic decisions on behalf of the shareholders. Bol and Blanche explain:

Operational Risk Management

While principals have a general awareness of agents’ responsibilities, agents possess the intricate details about the tasks and decisions being performed on the principals’ behalf. This disproportionate relationship invokes instability and distrust. Consider, for example, a CEO of a Fortune 500 company. The CEO has far more information about the appropriateness of strategic actions than any of the shareholders. As a result, when the CEO chooses which among a variety of strategic actions to pursue, he or she will likely select the one that is most beneficial to him or herself; such as, an investment project that materializes within the CEO’s tenure, even though it does not have the highest net present value. (2021)

In this example, notice that the CEO (the agent) is taking advantage of their position in the organization to benefit from financial gains. However, their actions are not in line with the best interests of the shareholders, whose aim is to maximize the net present value of the organization. It is not uncommon to find similar examples to the one above in different areas of a business. Indeed, Bol and Blanche explain that this agency relationship does not only happen between shareholders and executive board members, but that there are many organizational layers where this problem can arise. 

Between each hierarchical level of an organization resides an agency relationship, in which subordinates are hired to act on behalf of supervisors, and hence, agency problems are imminent. (Bol and Blanche, 2021)

Bol and Blanche continue to explain that the main cause behind the principal-agent problem is information asymmetry. This happens when one party — either the principal or the agent — has more information in the decision-making process than the other one: 

Information asymmetry in principal-agent relationships gives rise to moral hazard, whereby agents take unobserved actions in their own self-interest. Broadly speaking, moral hazard is when one party takes a risky or self-serving action knowing the other party will bear the negative consequences. This dynamic creates a temptation to ignore the moral implications of a decision: doing what benefits oneself the most instead of what one committed to. (Bol and Blanche, 2021)

This phenomenon of asymmetric information is what causes people to act in their best self-interest, which leads to moral hazard. In economics, moral hazard refers to a situation where one party takes a risky or self-serving action knowing the other party will bear the negative consequences. It is important to note that, even though the problem can go both ways (i.e., the principal has more information than the agent and benefits from it, or vice versa) it is usually the agent who uses information asymmetry to reap the benefits in a situation. This is because, as a delegatee, the agent is familiar with the day-to-day details of the task they have been assigned to perform. This means that they will be able to collect more information on the potential actions that can be taken for their individual benefit. 

Of course, the causes behind the principal-agent problem are not limited to information asymmetry. It may also be the case that agents act for their own benefit due to a lack of motivation or incentive to perform the task that the principal is asking. Equally, it may be attributed to the personalities involved and their inherent goodwill. Indeed, recent studies indicate that people who score highly in narcissism during personality tests are more likely subject to the principal-agent problem.

These root causes, in combination or in isolation, will give rise to the principal-agent problem. Broadly speaking, the main consequence of this problem is a clear misalignment and conflict in priorities, which leads to discontent and dissatisfaction on the principal or agent’s end. In agency theory, this dissatisfaction translates to “agency costs;” the price (financial and non-financial) that either the agent, principal or both parties incur from the conflict of interests. In A Theory of the Firm (2003), Michael C. Jensen goes into depth on the specific types of agency costs that exist, with an emphasis on “residual loss” as the overarching agency cost: 

The dollar equivalent of the reduction in welfare experienced by the principal as a result of this divergence is also a cost of the agency relationship, and we refer to this latter cost as the “residual loss.” We define agency costs as the sum of

1. the costs of creating and structuring contracts between the principal and the agent, 

2. the monitoring expenditures by the principal 

3. the bonding expenditures by the agent, and

Solutions for the principal-agent problem

Despite the agency costs that arise in a principal-agent relationship, it is important to note that the principal initially delegates a task or decision to the agent because they are convinced that the benefits of doing so will outweigh the costs. Therefore, the objective of agency theory is to minimise these costs to ensure that the principal’s initial hypothesis is indeed met. This dilemma is explained by Tom Delreux and Johan Adriaensen in The Principal Agent Model and the European Union (2017): 

The Principal Agent Model and the European Union

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.

In other words, the objective of agency theory is to find a solution to the conflict between principal and agent, which leads to agency costs. To solve this, incentives are designed to nudge and encourage people to behave in the optimal and desirable way. Going back to our organizational example, these incentives often take the form of bonuses or promotions, which motivate agents to align their actions with the principal’s desired outcome. The American business executive and public administrator Chester Barnard lists the types of incentives that can solve the principal-agent problem in his award-winning book The Functions of the Executive (1971). 

The Functions of the Executive

The specific inducements that may be offered are of several classes, for example: a) material inducements; b) personal non-material opportunities; c) desirable physical conditions; d) ideal benefactions. (1971)

When economists design incentives to encourage specific behaviors, they build them into contracts; shared agreements between principals and agents that ensure incentives are granted (conditional on the performance of a desired output). Indeed, as Samiran Banerjee mentions in Intermediate Economics (2021), contracts are carefully and mathematically modeled, accounting for the observable desired output and the incentive required to induce that output: 

Intermediate Microeconomics

The principal has to write a contract based on the observable output generated by the agent so as to induce him to undertake an action that is optimal from her perspective. While she runs the risk of not compensating him enough to motivate him to work hard, he runs the risk of working hard but getting inadequately compensated because hard work is not perfectly reflected in the output generated. Thus principal-agent contracts are predicated on optimal risk-sharing between the two parties. (2021)

Barnard also stresses how often material or financial incentives are ineffective to solve the principal-agent problem (which at the time were almost exclusively considered by economic theory): “even in purely commercial organizations, material incentives are so weak as to be almost negligible except when reinforced by other incentives” (1971). To solve this conundrum, other types of solutions must be put in place. For instance, in the shareholder-CEO example mentioned above, it might be optimal to gather the shareholders and executive board to discuss and realign on the objectives of the organization looking ahead.

More examples of the principal-agent problem

Throughout this article, we have focused our attention on the principal-agent problem in relation to organizations; the main focus of agency theory literature. However, there are a plethora of situations and day-to-day examples where we see this problem arising and being solved.

For example, a landlord (principal) delegates the rental of flats to a letting agency (agent). With a well-designed contract in place, the principal avoids any unintended agency costs such as the agent benefiting from exorbitantly high margins, or following unstandardized and biased criteria when choosing tenants.

The principal-agent problem can be extrapolated beyond the business world too, and can be found in such areas as politics and international affairs. For example, the relationship between voters and governments can be seen as a principal-agent problem, where voters (the principals) delegate the ruling and mandate of their nation to a government (the agent). The election manifesto and votes may be interpreted as the “contract” that both parties confidently sign to enact the desired policies. 

Equally, as editors Andreas Dür and Manfred Elsig summarize, The European Union’s Foreign Economic Policies (2014) discusses how the principal-agent model behaves in the context of different international relations and affairs:

The European Union's Foreign Economic Policies

The contribution by Conceição-Heldt investigates the relationship between the Commission (agent) and the member states as collective principal in the current Doha trade negotiations.

[...] The final contribution by Leblond looks at the strategic behaviour of an international institution (as agent) managing its relationship with multiple principals in the domain of accounting standards.

The contributors to the book choose to model international and public affairs as principal-agent relationships, because this approach takes into account the costliness and difficulty of implementing regulatory measures (or “contracts”, in principal-agent terminology) between the representatives of a principal and agent in different scenarios. As Dür and Elsig explain,

The main problem for the principal is that control is costly, requiring him to achieve a balance between agency losses and control costs. (2014)

To conclude, the principal-agent problem occurs when a principal (i.e., capital or resource owner) assigns an action or task to an agent and a conflict or misalignment of priorities exists between the two. This misalignment is often caused by asymmetric information, which induces the principal or agent to use this additional information to perform a self-serving action. This produces agency costs for the disadvantaged party, which can be mitigated through the design of contracts and incentives. These incentives do not necessarily have to be of a financial nature, though these are generally thought to be the most effective. The optimal contract or incentives will vary depending on the specific principal-agent scenario — whether in business, politics, or a range of other contexts.

To read more about the principal-agent problem in the context of the European Union, you can read Chapter 4 of The European Union’s Foreign Economic Policies (2014), edited by Andreas Dür and Manfred Elsig 

To read more about the mathematical models behind incentive design, you can read The Theory of Incentives (2009) by Jean-Jacques Laffont and David Martimort

To read more about the principal-agent problem in the context of public policy making and foreign affairs, you can read Public Administration & Public Management: The Principal-Agent Perspective (2006) by Jan-Erik Lane

To read about the principal-agent problem in the context of sports governance, you can read The EU in International Sports Governance: A Principal-Agent Perspective on EU Control of FIFA and UEFA (2016) by Arnout Geeraert

Banerjee, S. (2021) Intermediate Microeconomics. 2nd edn. Taylor and Francis. Available at: https://www.perlego.com/book/2194345/intermediate-microeconomics-a-toolbuilding-approach-pdf 

Barnard, C. (1971) The Functions of the Executive. Harvard University Press. Available at: https://www.perlego.com/book/2039368/the-functions-of-the-executive-thirtieth-anniversary-edition-pdf 

Bol, J. and Blanche, J. (2021) Operational Risk Management. Business Expert Press. Available at: https://www.perlego.com/book/2497210/operational-risk-management-organizational-controls-and-incentive-system-design-pdf 

Dür, A. and Elsig, M. (eds.) (2014) The European Union’s Foreign Economic Policies. Taylor and Francis. Available at: https://www.perlego.com/book/1662676/the-european-unions-foreign-economic-policies-a-principalagent-perspective-pdf 

Delreux, T. and Adriaensen, J. (eds.) (2017) The Principal Agent Model and the European Union. Springer International Publishing. Available at: https://www.perlego.com/book/3482755/the-principal-agent-model-and-the-european-union-pdf 

Jensen, M. (2003) A Theory of the Firm. Harvard University Press. Available at: https://www.perlego.com/book/3040049/a-theory-of-the-firm-governance-residual-claims-and-organizational-forms-pdf 

To read more about the personality traits that influence the principal-agent problem, read “The Impact of CEO Narcissism Behavior on Firm Performance through Earnings Management”

What is Conspicuous Consumption?

Behavioral Economics | Definition, Examples & Analysis

Behavioral economics (BE) is the study of economics from a psychological perspective. It aims to understand how individuals actually behave in different economic contexts by challenging the long-standing assumption that people behave rationally. Indeed, most of neoclassical economic theory assumes that individuals are rational, meaning they will act in their best self-interest to maximize profits or welfare. 

The father of behavioral economics, Richard Thaler, refers to these rational individuals as “Econs” (short for Homo economicus in Latin). These are people with the infinite ability to behave according to logical, theoretical principles and remain unmoved by emotions when making decisions. However, in his book Misbehaving (2015), Thaler explains that the world is not made up of these so-called Econs, but of humans who “misbehave” and act irrationally under many scenarios. As explained in Summary of Misbehaving, 

Summary of Misbehaving

The traditional economic theory of the 1970s presumed that people made economic decisions rationally. In this economic vision, rational individuals—or Econs, as Thaler calls them—know what they want, and they know how much they value the things they want. 

Behavioral economics, on the other hand, argues that the world is populated not by Econs, but by Humans. Humans are not always rational. They don’t always know what they want, or how much they value the things they want. In terms of traditional economic theory, Humans misbehave. (2016)

This observation, Thaler believed, was of special relevance in a policy-making context. Thaler argued that, when drafting new policies, it is extremely important to take the irrational (and realistic) reactions of populations into account in order to avoid unintended consequences (such as the financial crisis of 2008).

Although contemporary economist Richard Thaler is known as the “father of behavioral economics,” the origins of this discipline can be found earlier. Indeed, Adam Smith, English philosopher and economist of the 18th century, already questioned the concept of rationality in some of his less famous works such as The Theory of Moral Sentiments (1759, [2010]). 

The Theory of Moral Sentiments

The administration of the great system of the universe ... the care of the universal happiness of all rational and sensible beings, is the business of God and not of man. To man is allotted a much humbler department, but one much more suitable to the weakness of his powers, and to the narrowness of his comprehension: the care of his own happiness, of that of his family, his friends, his country.... But though we are ... endowed with a very strong desire of those ends, it has been entrusted to the slow and uncertain determinations of our reason to find out the proper means of bringing them about.

Other early critics of the concept of rationality such as Herbert A. Simon, George Katona, and James March emerged in the 1950s and 1960s. Most notably, Simon coined a term and theory to describe human irrationality during decision-making processes: “bounded rationality.” As he explains in his book Administrative Behavior (1947, [2013]), 

Administrative Behavior

Major attention will be given [...] to the ways in which people actually make decisions, and how their decision-making processes are molded by limits on their knowledge and computational capabilities (bounded rationality). 

However, up till then, behavioral economics was not making enough noise to be considered a discipline of its own. Psychologists Amos Tversky and Daniel Kahneman significantly amplified the volume with their contribution to the field; their well-known “prospect theory.” A summary of Daniel Kahneman’s award winning book Thinking Fast and Slow (2011) explains the bottom line of this theory, which revolutionized economics by challenging traditional utility theory: 

Summary and Analysis of Thinking, Fast and Slow

For Kahneman, the most important takeaways from prospect theory are that reference points exist, and losses always loom larger than corresponding gains in our perception. Therefore, because existing terms provide reference points for negotiations, people tend to fight harder to prevent losses than they do to achieve gains, and they have a sense of unfairness or entitlement which pushes them to feel that their losses are unjust. (2017)

By the late 1900s, behavioral economics was beginning to acquire enough research and literature to be considered a distinct branch of economics. Such was the case that, in the 2000s, the prestigious Quarterly Journal of Economics started publishing an issue which was entirely dedicated to new research and discoveries in the field of behavioral economics — a huge achievement for BE as a discipline. Richard Thaler led the way during these ambitious years with a positive future outlook. Along with other renowned economists, he published numerous papers which allowed the field to continue growing and maturing. Thaler is famously known for developing nudge theory together with Cass R. Sunstein which, as explained in the book Why Nudge? (Sunstein, 2014), refers to the importance of altering and designing environments to influence the likelihood of people choosing one option over another. Sunstein argues that

Why Nudge?

In light of the pervasive risk of government error and the inescapable fact of human diversity, it is usually best to use the mildest and most choice-preserving forms of intervention. These forms include “nudges,” understood as initiatives that maintain freedom of choice while also steering people’s decisions in the right direction (as judged by people themselves). (2014)

For example, according to nudge theory, if you want to influence students to eat healthily in school canteens, this can be achieved by “nudging” students to select healthier dishes by placing these first in the buffet. To date, nudge theory is one of the concepts within behavioral economics which receives the most attention and awe from the general public. 

Figure 1 - Some of the most influential behavioral economists 

Today, behavioral economics is still considered a relatively young field in economics. For this reason, it is a very attractive domain for prospective economists, psychologists, and researchers — or anyone who feels the itch to refine economic models by accounting for human psychology and irrationality. 

Some principles and examples of behavioral economics

Because behavioral economics defies the idea that humans behave rationally when making decisions, it proposes a selection of generalizable situations or principles to illustrate this in practice. These principles are often referred to as cognitive biases and can be thought of as the themes or subtopics studied within behavioral economics. They are backed by experiments and research that demonstrate how human psychology intervenes when people actually make decisions in economic situations. 

The anchoring and framing effects were conceptualized by Daniel Kahneman and Amos Tversky. In his book Thinking Fast and Slow (2011), Kahneman explains that anchoring is “the tendency to rely too much on an initial piece of random information—the anchor—which is then used to make subsequent decisions.” For example, say you are looking to buy a shirt. The first one you see costs £20, and the second one £10. The anchoring effect will make you think that the second shirt was “cheap” because you took the price of the first one as a reference, base rate or anchor — influencing your purchasing decision. 

Framing instead happens when “we make choices based on whether they are presented as gains or losses” (Kahneman, 2011). That is, communicating information in one way or another will affect our decision-making. A typical example is when we are presented with two yogurt options in a supermarket, with one labeled as containing “20% fat” and the other one as being “80% fat free.” The second option is generally perceived to have less fat content. This, in turn, will affect the choice the customer makes despite both products being the same. 

The idea that most people have a strong preference for avoiding losses as opposed to acquiring gains is known as loss aversion. This concept was, again, jointly developed by Kahneman and Tversky as a crucial part of their prospect theory. Kahneman and Tversky explain that 

Choices, Values, and Frames

One of the basic phenomena of choice under both risk and uncertainty is that losses loom larger than gains (Kahneman and Tversky, 1984; Tversky and Kahneman, 1991). The observed asymmetry between gains and losses is far too extreme to be explained by income effects or by decreasing risk aversion. (“Advances in Prospect Theory: Cumulative Representation of Uncertainty,” 1992, in Choices, Values, and Frames, 2000) 

This bias often appears when we make decisions that involve risk. For example, people generally prefer investing in safe stocks with lower returns on investment than risky ones with higher returns. 

Introduced by Richard Thaler, mental accounting explains why we often make irrational purchases that we were not anticipating and which we often can’t afford. It refers to the human tendency to compartmentalize our purchases into different mental categories (e.g., entertainment, food, clothes etc.) and assign mental budgets for each of these. For example, say you definitely spent too much on restaurants in the past month, but have come across a beautiful pair of shoes which you cannot resist. Because restaurants and shoes belong to different mental accounting departments (e.g., food vs. clothes), you allow yourself to get those shoes even if your budget doesn’t allow it. In Dollars and Sense (2017), Dan Ariely and Jeff Kreisler cover this bias in depth, providing the below example: 