Principal–agent problem

The principal-agent theory or agency theory ( sometimes also called principal-agent model) is an upcoming model from the economics of the New Institutional Economics. This theory, however, is well established in the social sciences, sociology and political science. The term principal-agent theory is derived from the original English term principal- agent theory and the corresponding principal- agent problem-.

This principal refers to the principal and agent, the officer. The latter usually has thereby a knowledge advantage (information asymmetry), which can be used in different ways either in favor or detriment of the principal. The theory thus offers a model to explain the actions of people and institutions in a hierarchy. In addition, she meets general statements about design of contracts.

History

The theory was first discussed in a paper by Michael Jensen and William Meckling in 1976. Their main features are due to the incomplete contract theory, which established, among other things Ronald Coase.

Assumptions

The principal-agent theory assumes that economic agents who are restricted in their decision making, such as asymmetric information. You only have incomplete information if they are to judge the actions of others.

Further, the parties assumed opportunism. In a broad definition, there is a principal-agent relationship, as soon as the well-being of one party ( principal) of the actions of another party (agent) is dependent. After close definition, there is a client (principal) that a contractor (Agent) appointed by mutual agreement to pay with a task. Since the two different goals can track it can cause conflicts.

In addition, risk propensities are considered: In principle, on both sides of risk neutrality, risk aversion or risk-taking possible. This depends on the characteristics and situation of the actors.

The principal instructed the agents in the hope that this does its job in terms of principal. He may, however, recognize the commitment and / or the qualities of his agents only with restrictions and looks - if at all - only the result of his efforts. In contrast, the agent has an information advantage because he knows better the quality of their own and can specify the behaviors themselves and good judge accordingly. He will take advantage of this information asymmetry to the detriment of the principal, if this is his own purposes relevant ( moral hazard and shirking ).

Common Problems

Overview

Various types of problems can trigger disturbances in the relationship between principal and agent. The disposal gives rise to agency costs. These are composed of the costs of signaling, screening, and the remaining loss of welfare between the best possible and existing solution. This agency costs may not surpass the existing welfare loss, otherwise the actions of the parties would be classified as inefficient. The problems between principal and agent can be divided into adverse selection, moral hazard and categorize hold-up.

Hidden Features

A first problem concerns hidden field properties (german hidden characteristics ) and the resulting risk of adverse selection. Prior to contracting (ex ante) the agent to the principal is relatively unknown in certain circumstances. The principal may have chosen the wrong candidate as an agent due to the lack of knowledge of the properties. To avoid this, the agent must send clear signals that can be imitated by a worse competitor ( "Signaling ", for example, by presentation of a high school diploma ). Also, the principal can remedy this lack of information, by performing a so-called "screening" (eg by selection in an assessment center ). Another solution to the problem results from "Self Selection", by presenting the agent several contracts between which the agent is allowed to choose. Of the decision made by the agent selection of the principal can draw a conclusion about possible strategies of the agents.

Conversely, come with hidden features an actual agent to a principal. An example of the relationship between an employee and a contractor who paid foreign workers would not or incomplete. In this case, there is a dual, oppositely directed principal-agent relationship. Regarding the nature of his work of construction workers is an agent with respect to the contractor (principal). However, considering the payment obligations of the contractor, so this is an agent with respect to the foreign workers. The contractor may withhold the foreign construction workers, for example, information about the right to a minimum wage or otherwise defraud him of his, he is entitled payment.

Hidden action and hidden information

For the types of problems hidden action ( hidden action ) and hidden information (hidden information ), however, the information asymmetries occur only ex post, ie after conclusion of the contract and during the contract. Hidden action means that the agent has discretionary leeway, since the principal 's actions ( complete) can not observe. Hidden information is available on the other hand, if the principal indeed observe the actions, but their quality (eg due to lack of expertise ) can not be estimated.

In both cases, there is a moral hazard. The problem is based in the fact that the principal and ex post can not judge whether the resulting result was achieved through skilled efforts of the agent, or whether (or how much ) the environmental conditions have influenced the results.

Hidden intention

Even if the principal has opportunities to observe the actions of the agent, ie when there is no hidden action or hidden information available, it can lead to problems in that the principal ex ante not the intentions of the agent knows, in certain cases still. This is referred to as a hidden intention ( hidden intention ). As a consequence, a hold-up problem occurs.

In exchange goods only hidden properties can be a problem when the contract goods, however, represent hidden information and hidden action a potential hazard dar.

Optimization of asymmetric information

The principal-agent theory is based on asymmetric information. Therefore, the best solution would be theoretically possible in the case of symmetric information, not given. It is thus based on asymmetric information and the information deficiencies are not corrected, then only one third-best solution can be reached. The aim must therefore be to achieve at the given information deficiencies still at least a second-best solution. For this, however, agency costs must be applied.

Resolution mechanisms

Attempts to mitigate the principal-agent problem by the following mechanisms or even to fix:

• Bureaucratic Control ( hierarchy)
• Information systems ( controlling, time tracking, milestones)
• Incentives (incentives, bonuses, see also incentive system )
• Corporate Culture
• Reputation
• Trust

Effective systems are especially which give the agent an incentive for proper behavior. Through a performance-related pay, the goals of the agent to be aligned with the objectives of the principal. We distinguish several incentive schemes:

• The " all-or- nothing " principle, whereby the agent is paid on a particular result
• Lease, the agent emits a fixed amount to the principal and possibly retain a surplus may
• Fixed wage, the agent is paid regardless of the outcome (no incentive )
• Share Cropping, with the profit between principal and agent is shared proportionally.

Each system has its strengths and weaknesses in terms of risk distribution, incentive intensity and control action.

A corporate culture can lead to the reduction of agency costs. Similarities in preferences, values, goals and competencies minimize coordination costs. This facilitates mutual coordination and learning. The efficiency aspects dominate, but they are undermined by the homogeneous culture: Longer-term relationships often call with homogeneous cultures transaction-specific investments show that increase dependencies and allow it to exploit the weak and to behave opportunistically.

Reputation can be interpreted as a specific asset that must be defended, the more opportunities exist for opportunism. A good reputation reduces the incentive for opportunistic behavior and for this reason it reduces information and transaction costs (ex ante).

Application

One example is the employment relationship in which the employee (agent) knows better what stake he works for his employer (principal). The principal-agent theory tries to find a way out of these conflicts in order to maximize the overall economic benefit of all involved. In the example of the employee, the employer may therefore be monitoring the work of the employees or pay him based on performance in order to defuse the conflict of interests of the parties (interest alignment). Another alternative would be to threaten for breach of contract with the loss of work. Contractors are often linked via a bond to the contractual agreements.

Scientific Importance

The principal-agent theory is now next to the transaction cost theory, the theory of property rights and the resource theory of the leading approaches to explanation are discussed and applied in economics.

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