|
In a principal-agent relationship the principal cannot
have full information regarding the work of the agent, thus the principal must
rely on proxy indicators.
Two particularly important consequences of this reliance
are “adverse selection” and “moral hazard.”
In general, the principal must rely on indicators of
success rather than success itself (adverse selection), while the
agent directs attention toward the satisfaction of proxy measures rather
than toward the success of the task itself. (moral
hazard). [1]
The “hazard” in moral hazard refers to the fact that the
individual has an incentive to direct behavior toward proxy measures rather
than toward the desired goal. This
redirection can result in a creating incentives
for perverse behavior.
The “adverse” in adverse selection refers to the fact
that the establishment of monitoring criteria leads to perverse
measurement.
Consider the case of buy-outs. Capitalism is a risky business. But if taxpayers were to assume all the risk
of bailouts there would be no market punishment for management inefficiency
or corruption. One argument against
publicly financed remedies for such tragedies as the Enron debacle is that
this would change the incentives such that managers may think that the
costs of risk they take will be borne by someone else and, accordingly,
they would be prepared to take big risks.
Consider the case of hostage-taking. If the U.S. were to act humanely and
try to come to the aid of hostages of terrorists, it would encourage
terrorists to think that hostage-taking was a productive enterprise,
thereby possibly encouraging more hostage-taking. “Based upon past experience, the U.S.
Government concluded that making concessions that benefit hostage takers in
exchange for the release of hostages increased the danger that others will
be taken hostage. U.S. Government policy is, therefore, to deny hostage
takers the benefits of ransom, prisoner releases, policy changes, or other
acts of concession.” [2]
1. Daniel W. Bromley, Economic Interests and Institutions: The
Conceptual Foundations of Public Policy
(Oxford: Basil Blackwell, 1989).
2. U.S. Department of State,
Richard Boucher, Washington,
DC, February 20, 2002. International
Terrorism: American Hostages.
|