The principal–agent problem (often abbreviated agency problem) refers to the conflict in interests and priorities that arises when one person or entity (the "agent") takes actions on behalf of another person or entity (the "principal").. The problem worsens when there is a greater discrepancy of interests and information between the principal and agent, as well as when the principal lacks the means to punish the agent. The deviation of the agent's actions from the principal's interest is called "agency cost".Pay Without Performance, Lucian Bebchuk and Jesse Fried, Harvard University Press 2004 (preface and introduction )
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). In all these cases, the principal has to be concerned with whether the agent is acting in the best interest of the principal. Principal-agent models typically either examine moral hazard (hidden actions) or adverse selection (hidden information).
The principalagent 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 the principal's best interest, 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.
The agency problem can be intensified when an agent acts on behalf of multiple principals (see multiple principal problem). When multiple principals have to agree on the agent's objectives, they 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. The multiple principal problem is particularly serious in the public sector.
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's interests are expected to be pursued by the agent; however, when the interests of the agent and principal differ, a dilemma arises. The agent possesses resources such as time, information, and expertise that the principal lacks. At the same time, the principal does not have control over the agent's ability to act in the agent's own best interests. In this situation, the theory posits that the agent's activities are diverted from following the principal's interests and drive the agent to maximize the agent's interests instead.
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 both claiming authorship. Ross is said to have originally described the dilemma in terms of a person choosing a flavor of ice-cream for someone whose tastes they do not know (Ibid). The most cited reference to the theory, however, comes from Michael C. Jensen and William Meckling. 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 the quantity and quality of information available about the performance of individual employees, the ability of employees to bear risk, and the ability of employees to manipulate evaluation methods, the structural details of individual contracts vary widely, including such mechanisms as "piece rates, [share] options, discretionary bonuses, promotions, profit sharing, efficiency wages, deferred compensation, and so on". Typically, these mechanisms are used in the context of different types of employment: salesmen often receive some or all of their remuneration as commission, production workers are usually paid an hourly wage, while office workers are typically paid monthly or semimonthly (and if paid overtime, typically at a higher rate than the hourly rate implied by the salary). The way in which these mechanisms are used is different in the two parts of the economy which Doeringer and Piore called the "primary" and "secondary" sectors (see also dual labour market).
The secondary sector is characterised by short-term employment relationships, little or no prospect of internal promotion, and the determination of wages primarily by market forces. In terms of occupations, it consists primarily of low or unskilled jobs, whether they are blue-collar (manual-labour), white-collar (e.g., filing clerks), or service jobs (e.g., waiters). These jobs are linked by the fact that they are characterized by "low skill levels, low earnings, easy entry, job impermanence, and low returns to education or experience". In a number of service jobs, such as food service, golf caddying, and valet parking jobs, workers in some countries are paid mostly or entirely with tips.
The use of tipping is a strategy on the part of the owners or managers to align the interests of the service workers with those of the owners or managers; the service workers have an incentive to provide good customer service (thus benefiting the company's business), because this makes it more likely that they will get a good tip.
The issue of tipping is sometimes discussed in connection with the principal–agent theory. "Examples of principals and agents include bosses and employees ... [and] diners and waiters." "The "principal–agent problem", as it is known in economics, crops up any time agents aren't inclined to do what principals want them to do. To sway them [(agents)], principals have to make it worth the agents' while ... [in the restaurant context,] the better the diner's experience, the bigger the waiter's tip."Paula Szuchman, Jenny Anderson. It's Not You, It's the Dishes (originally published as Spousonomics): How to Minimize Conflict and Maximize Happiness in Your Relationship. Random House Digital, Inc., June 12, 2012. Page 210. Accessed on May 31, 2013 "In the ... language of the economist, the tip serves as a way to reduce what is known as the classic "principal–agent" problem." According to "Videbeck, a researcher at the New Zealand Institute for the Study of Competition and Regulation[,] '[i]n theory, tipping can lead to an efficient match between workers' attitudes to service and the jobs they perform. It is a means to make people work hard. Friendly waiters will go that extra mile, earn their tip, and earn a relatively high income...[On the other hand,] if tipless wages are sufficiently low, then grumpy waiters might actually choose to leave the industry and take jobs that would better suit their personalities.'"
As a solution to the principal–agent problem, though, tipping is not perfect. In the hopes of getting a larger tip, a server, for example, may be inclined to give a customer an extra large glass of wine or a second scoop of ice cream. While these larger servings make the customer happy and increase the likelihood of the server getting a good tip, they cut into the profit margin of the restaurant. In addition, a server may dote on generous tippers while ignoring other customers, and in rare cases harangue bad tippers.
Non-financial compensation Part of this variation in incentive structures and supervisory mechanisms may be attributable to variation in the level of intrinsic psychological satisfaction to be had from different types of work. Sociologists and psychologists frequently argue that individuals take a certain degree of pride in their work, and that introducing performance-related pay can destroy this "psycho-social compensation", because the exchange relation between employer and employee becomes much more narrowly economic, destroying most or all of the potential for social exchange. Evidence for this is inconclusive—Deci (1971), and Lepper, Greene and Nisbett (1973) find support for this argument; Staw (1989) suggests other interpretations of the findings.
Incentive structures as mentioned above can be provided through non-monetary recognition such as acknowledgements and compliments on an employee (agent) in place of employment. Research conducted by Crifo and Diaye (2004) mentioned that agents who receive compensations such as praises, acknowledgement and recognition help to define intrinsic motivations that increase performance output from the agents thus benefiting the principal.
Furthermore, the studies provided a conclusive remark that intrinsic motivation can be increased by non-monetary compensations that provide acknowledgement for the agent. These higher rewards, can provide a principal with the adequate methodologies to improve the effort inputs of the agent when looking at the principal agent theory through an employer vs employee level of conduct.
Team production On a related note, Drago and Garvey (1997) use Australian survey data to show that when agents are placed on individual pay-for-performance schemes, they are less likely to help their coworkers. This negative effect is particularly important in those jobs that involve strong elements of "team production" (Alchian and Demsetz 1972), where output reflects the contribution of many individuals, and individual contributions cannot be easily identified, and compensation is therefore based largely on the output of the team. In other words, pay-for-performance increases the incentives to free-ride, as there are large positive externalities to the efforts of an individual team member, and low returns to the individual (Holmström 1982, McLaughlin 1994).
The negative incentive effects implied are confirmed by some empirical studies, (e.g., Newhouse, 1973) for shared medical practices; costs rise and doctors work fewer hours as more revenue is shared. Leibowitz and Tollison (1980) find that larger law partnerships typically result in worse cost containment. As a counter, peer pressure can potentially solve the problem (Kandel and Lazear 1992), but this depends on peer monitoring being relatively costless to the individuals doing the monitoring/censuring in any particular instance (unless one brings in social considerations of norms and group identity and so on). Studies suggest that profit-sharing, for example, typically raises productivity by 3–5% (Jones and Kato 1995, Knez and Simester 2001), although there are some selection issues (Prendergast).
Empirical evidence