Principal–agent

problem

The principal–agent problem, in political science, supply chain management and economics
(also known as agency dilemma or the agency problem) occurs when one person or entity (the
"agent"), is able to make decisions and/or take actions on behalf of, or that impact, another
person or entity: the "principal".[1] This dilemma exists in circumstances where agents are
motivated to act in their own best interests, which are contrary to those of their principals, and is
an example of moral hazard. Issues also arise when companies have an incentive to become
increasingly deferential to management that have ownership stakes.[2]:725,741 As shareholders
are dis-incentived to intervene, there are fewer checks on management.[2]:725,741 Issues can also
arise among different types of management.

Basic idea of agency theory.

Common examples of this relationship include corporate management (agent) and shareholders
(principal), elected officials (agent) and citizens (principal), or brokers (agent) and markets
(buyers and sellers, principals).[3] Consider a legal client (the principal) wondering whether their
lawyer (the agent) is recommending protracted legal proceedings because it is truly necessary
for the client's well-being, or because it will generate income for the lawyer. In fact the problem
can arise in almost any context where one party is being paid by another to do something where
the agent has a small or nonexistent share in the outcome, whether in formal employment or a
negotiated deal such as paying for household jobs or car repairs.

The principal–agent problem typically arises where the two parties have different interests and
asymmetric information (the agent having more information), such that the principal cannot
directly ensure that the agent is always acting in their (the principal's) best interest,[4] particularly
when activities that are useful to the principal are costly to the agent, and where elements of
what the agent does are costly for the principal to observe (see moral hazard and conflict of
interest). Often, the principal may be sufficiently concerned at the possibility of being exploited
by the agent that they choose not to enter into the transaction at all, when it would have been
mutually beneficial: a suboptimal outcome that can lower welfare overall. The deviation from the
principal's interest by the agent is called "agency costs".[4]

The agency problem can be intensified when an agent acts on behalf of multiple principals (see
multiple principal problem).[5] When one agent acts on behalf of multiple principals, the multiple
principals have to agree on the agent's objectives, but face a collective action problem in
governance, as individual principals may lobby the agent or otherwise act in their individual
interests rather than in the collective interest of all principals.[6] As a result, there may be free-
riding in steering and monitoring,[7] duplicate steering and monitoring,[8] or conflict between
principals,[9] all leading to high autonomy for the agent. The multiple principal problem is
particularly serious in the public sector, where multiple principals are common and both
efficiency and democratic accountability are undermined in the absence of salient
governance.[5][10][11] This problem may occur, for example, in the governance of the executive
power, ministries, agencies, intermunicipal cooperation, public-private partnerships, and firms
with multiple shareholders.[5]

The relationships between investment managers and corporate management is an especially

common example of the principal–agent relationship. There are several drivers of agency
problems that affect investment managers of index funds and mutual funds include.[12]:90 First,
investment managers receive a fraction of the benefits resulting from stewardship activities
while having to handle all the costs. competition among investment managers is can also
contribute to agency problems.[12]:90And, lastly, another driver of agency problems is that
investment managers can be heavily influenced by private incentives provided by the managers
of corporations.[12]:90

Various mechanisms may be used to align the interests of the agent with those of the principal.
In employment, employers (principal) may use piece rates/commissions, profit sharing,
efficiency wages, performance measurement (including financial statements), the agent posting
a bond, or the threat of termination of employment to align worker interests with their own.

Overview

The principal and agent theory emerged in the 1970s from the combined disciplines of
economics and institutional theory. There is some contention as to who originated the theory,
with theorists Stephen Ross and Barry Mitnick claiming its authorship.[13] Ross is said to have
originally described the dilemma in terms of a person choosing a flavor of ice-cream for
someone whose tastes he does not know (Ibid). The most cited reference to the theory, however,
comes from Michael C. Jensen and William Meckling.[14] The theory has come to extend well
beyond economics or institutional studies to all contexts of information asymmetry, uncertainty
and risk.

In the context of law, principals do not know enough about whether (or to what extent) a
contract has been satisfied, and they end up with agency costs. The solution to this information
problem—closely related to the moral hazard problem—is to ensure the provision of appropriate
incentives so agents act in the way principals wish.

In terms of game theory, it involves changing the rules of the game so that the self-interested
rational choices of the agent coincide with what the principal desires. Even in the limited arena
of employment contracts, the difficulty of doing this in practice is reflected in a multitude of
compensation mechanisms and supervisory schemes, as well as in critique of such
mechanisms as e.g., Deming (1986) expresses in his Seven Deadly Diseases of management.

Employment contract

In the context of the employment contract, individual contracts form a major method of
restructuring incentives, by connecting as closely as optimal the information available about
employee performance, and the compensation for that performance. Because of differences in
and Baker (1992), this has become known as "multi-tasking" (where a subset of relevant tasks is
rewarded, non-rewarded tasks suffer relative neglect). Because of this, the more difficult it is to
completely specify and measure the variables on which reward is to be conditioned, the less
likely that performance-related pay will be used: "in essence, complex jobs will typically not be
evaluated through explicit contracts." (Prendergast 1999, 9).

Where explicit measures are used, they are more likely to be some kind of aggregate measure,
for example, baseball and American Football players are rarely rewarded on the many specific
measures available (e.g., number of home runs), but frequently receive bonuses for aggregate
performance measures such as Most Valuable Player. The alternative to objective measures is
subjective performance evaluation, typically by supervisors. However, there is here a similar
effect to "multi-tasking", as workers shift effort from that subset of tasks which they consider
useful and constructive, to that subset which they think gives the greatest appearance of being
useful and constructive, and more generally to try to curry personal favour with supervisors.
(One can interpret this as a destruction of organizational social capital—workers identifying with,
and actively working for the benefit of, the firm – in favour of the creation of personal social
capital—the individual-level social relations which enable workers to get ahead ("networking").)

Linear model

The four principles can be summarized in terms of the simplest (linear) model of incentive
compensation:

where w (wage) is equal to a (the base salary) plus b (the intensity of incentives provided to the
employee) times the sum of three terms: e (unobserved employee effort) plus x (unobserved
exogenous effects on outcomes) plus the product of g (the weight given to observed exogenous
effects on outcomes) and y (observed exogenous effects on outcomes). b is the slope of the
relationship between compensation and outcomes.

The above discussion on explicit measures assumed that contracts would create the linear
incentive structures summarised in the model above. But while the combination of normal errors
and the absence of income effects yields linear contracts, many observed contracts are
nonlinear. To some extent this is due to income effects as workers rise up a
tournament/hierarchy: "Quite simply, it may take more money to induce effort from the rich than
from the less well off." (Prendergast 1999, 50). Similarly, the threat of being fired creates a