Principal-Agent Problem

The principal-agent problem is a central concern of institutional economics Opens in new window and may be addressed by appropriate rules.

The principal-agent problem is a conflict that arises whenever people act as agents for others, whom we call principals, and when the agents have better knowledge about the operation than the principals (asymmetric information).

It is then possible that agents act in their own interest and neglect the interests of the principals (shirking, opportunistic behavior). This problem is prevalent in big business and big government and presents a major management challenge.

Agents and Principals

Since motivation by altruism Opens in new window is normally limited to small groups and coercion is wasteful and ineffectual, problems arise when people act on behalf of someone else to whom they are not very close. In other words, people act as agents for principals.

For example:
  • The owners of a firm employ staff to do work for them.
  • Managers run the day-to-day operations of a business that belongs to shareholders.
  • Citizens elect politicians to make certain decisions on their behalf.

In these cases, agents may be tempted to act opportunistically in the knowledge that they will get away with it, since the principals are often not well informed or remain ‘rationally ignorant Opens in new window’ about the details of the agent’s actions.

Principals may incur high monitoring costs if they want to find out what the agents are really doing, as information is asymmetric: the agent knows more than the principal. Consequently, workers may get away with shirking some of their duties although they could work harder.

Business managers may prefer the good life and satisfice, whereas it would be in the interest of the owners of the business (the principals) if they behaved in more risky, creative-entrepreneurial ways.

And the citizens, who are the principals in a political community, often do not get from government officials what they really want, because parliamentarians and officials pursue their own selfish purposes.

These conflicting interests defines the principal-agent problem. It is a consequence of the knowledge problem and the natural limits of solidarity with others.

When people feel they can get away with opportunistic behavior Opens in new window, because those whom they short-change do not know and will not find out, they fall prey to moral hazard.

The term moral hazard Opens in new window was first used in insurance: The insured fail to take proper precautions to avoid damage and only they know what full precaution could achieve in particular circumstances.

Thus, agents are exposed to moral hazard when the principals are ignorant or the agents are not constrained by appropriate rules.

The principal-agent problem is considerable in big business and government organizations. Agents then tend to busy themselves with activities they themselves find agreeable, but not necessarily activities that serve the purpose(s) of the enterprise to sell at a profit for the owners or achieve other objectives set by the principals.

To deal with this, high organization costs may have to be incurred.

Managers of a firm may come up with plans for numerous meetings in pleasant places, interesting research projects, in-service courses and coordination committees, which detract from their obligation to shoulder responsibilities for risk-taking.

They may justify a need to travel and a whole host of other seemingly essential activities that amount to on-the-job consumption.

There are many ways which occupy work time pleasantly and add to overhead costs without making sufficient contributions to the profit. Yet, outsiders, including the owners of the firm, do not know which of those costs are necessary and which not.

How to Motivate Agents

Wherever people employ agents to act on their behalf, the motivation of the agents requires attention. The types of motivation, which are discussed in preceding post Opens in new window, may be employed by the principals to ensure that their agents act to the best of their capabilities.

  1. Agents can be inspired to make the principals’ goals their own out of solidarity.
    Where only few people are involved, say in a small firm, collaborators can be very loyal to the owner or owners. They may use direct appeals to their colleagues to perform well; and even in bigger operations collaborators can be educated in habits of loyalty to the principals, which then saves on monitoring and other transaction costs.
  2. Agents can be controlled by direct supervision and direct commands. They may be guided by instructions and subjected to penalties if they do not follow the instructions, as long as the principals keep themselves informed about the agents’ actions and potential scope for improvement.
  3. Agents may be required to follow general rules, which create incentives for them to pursue the principals’ interests. Thus, businesses may offer their workers performance pay to promote profitability or investment funds to give their managers a share in improved asset values. These are ways to draw on the agent’s self-interest (indirect control).
An example of direct control of possibly opportunistic agents is the supervision of workers in a factory to see whether they meet targets and produce the output quantities and qualities that the management has planned.

This requires much detailed knowledge on the part of the principals and supervisors and may cause high monitoring costs, especially when the production task becomes complex.

The alternative is to appeal—as far as possible—to the self-motivation of the agents by rules and incentives which induce them to do the principals’ biding voluntarily, for example by paying the workers pieces rates or rewarding quality output.

Important indirect controls of agent opportunism also derive from competition.

This demonstrates to the agents that they risk losing their jobs if they do not perform to the best of their ability in promoting the principals’ purposes.

This can be made explicit, for example, by benchmarking and competitions between different work teams.

Massive principal-agent problems arose under socialism Opens in new window, a doctrine that claimed the moral high ground, rejecting motivation by selfishness (that is, by competing to earn a high return in a market). Alas, solidarity with ‘society’ turned out to be rather limited in practice.

The principles therefore had to rely on coercion, but found themselves confronted with insurmountable information and monitoring costs. The principals were simply unable to know what production was possible, what innovations might be feasible and what resources could be saved. Their capacity to coerce and punish ‘their’ workers was extremely limited. Shirking Opens in new window became almost universal (Gregory, 1990 and Section 13.1).

In the end, the system collapsed in the Soviet Union, because of the failure to cope with the principal-agent problem, but the command-and-control approach is still relied upon in many places, from socialist production in Venezuela and Cuba to the provision of health and education services in Western welfare states.