Class Notes--Gregory Gleason 

Theory of Agency and Contracts

Including the "Principal-Agent Relationship"


When a party makes an agreement with another party to carry out a task we can speak of the function of "agency."

The principal--the party assigning the task--contracts with an agent--someone hired to carry out a task--to use the asset under specified conditions in exchange for some benefit. Philosophers and legal scholars have long investigated the principal-agent relationship. It is discussed in the works of Plato and Hegel. The principal-agent relationship is at the foundation of modern contract law. It is the starting point for some of the most productive theoretical work in contemporary economic theory.

The important point here is that when people agree to work together--to cooperate--whether that is within a hierarchy or on a lateral basis, a kind of contract is invoked. This is clear in the case of lateral exchanges in a context that we call a market. The fundamental idea of the market is that exchanges take place on a voluntary basis. For instance, some of the most famous propositions of the market system, in their simplicity and straightforwardness express this clearly: "A willing buyer and a willing seller." It is thus a contractual relationship but a lateral one.

Some hierarchical relationships are more difficult to see as contracts, but it is clear that in wage relationships--when someone hires the labor of a worker--the relationship is contractual. A willing buyer (the boss) and a willing seller (the worker). More extreme hierarchical relationships, one thinks of corvee labor, conscripted labor, convict labor, and so on, do not have the ready element of willingness to them and may therefore seem to us to be less than contractual.  But the difference here is mo re of degree than quality. Even the jailer depends to some extent on the willingness of the inmate to cooperate.

These reflections on the contractual nature of relationships bring us to a general definition. An agency relationship is established when one actor--the principal--assigns some rights and responsibilities to another actor--the agent--in such a way that the principal forms a contract with the agent to represent the principal's interests in return for some form of compensation. This is the principal-agent relationship.
What are examples of principal-agent relationships?

master and slave
landlord and tenant
shop foreman and line worker
manager and personnel
patient and physician
voter and elected representative--one party (the public) contracts with another (the public servant) to do a job.

Sometimes these contractual relationships are more opaque than at other times. Consider students and teacher. Is the teacher or the students the contractor or contractee? In 19th century Europe, the students contracted with the teachers.

Agency, Interests, and Hazards 

The principal has certain incentives in this relationship that differ from those of the agent. The principal is mainly concerned about the achievement of a task, while the agent is concerned about receiving remuneration.

What we know about human behavior and the theory of action, in particular the theory of rational action, suggests that people will act in such a way as to maximize their interests. We do not have to assume that people are selfish, self-interested, self- promoters, etc. to notice that in most contractual relationships there is a difference between the preferences of the contractor and the contractee.  In a contractual relationship, that is an "agency relationship," even altruistic and cooperative actors w ill find that they have trouble coordinating their actions with their counterpart in the relationship.

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 the toward the success of the task itself. (moral hazard).

From the point of view of the principal, the basic problem that is encountered in the agency relationship is shirking and opportunism. The agent may say he or she has accomplished a task. The agent may indeed perceive that the task has been accomplished . The agent may have had to rely upon other agents to get the task accomplished. If these secondary agents did not perform the task the fully, the shirking may be pushed up the line. There are other "human" but very important considerations that must b e borne in mind in analyzing a principal-agent relationship. For instance, if the agent is very successful in accomplishing the task, the principal may come to see the agent as challenger, perhaps even as a potential successor and thus a rival. Ask any vice-president of anything what is most important about doing the job. She or he will tell you that the most important thing is that the president succeeds.

From the point of view of the agent, the basic problem is ratcheting.  If the task is easily accomplished, the next time a contract is negotiated, there may be a tendency for the principal to establish more difficult targets. The agent may see the goals as different from the ones defined in the contractual relationship. Thus the agent may have a different agenda, a different interpretation.

How can we analyze these differences?  Notice some features.

1) Interests, preferences, and capabilities are different But since the interests of the principals and agents do not always coincide, agents are likely to make suboptimal decisions from the principal's viewpoint unless they are constrained through monitoring or oversight.
2) Capacities are different The agent usually has more information.
3) Coordination is the principal's task. The principal has to coordinate even if there are no problems of shirking and opportunism.
4) Agents can use their resources to redefine the goals and tasks to change the objectives. This is not opportunism, but self-promotion or promotion of some form of separate agenda.
5) Agents have subagents and other forms of constituencies.

Multilateral donor organizations and national foreign aid agencies naturally are anxious to focus assistance to spur beneficial economic and political development. Using aid to incentivize progressive change is in general a good idea. But this implies that governments that waver in their commitment to economic reform are sometimes offered donor incentives to urge them forward. This practice leads to the unfortunate moral hazard of rewarding fence-straddling and punishing success. 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.

Agency and Incentives 

How can the principal reduce the burdens associated with agency shirking and opportunism? A few instruments are monitoring, profit sharing and bonding. IN bonding the agent offers some collateral.

Usually we think of rewards when we think of incentives. What is a reward? All rewards are based upon the fundamental proposition that "if you do something good, something good will happen to you. If you do something bad, something bad will happen to you."  Incentive Structures include: 

inducements/sanctions
rewards/penalties
incentives/disincentives
encouragement/discouragement
carrot/stick

Rewards are effective at producing temporary compliance, but often fail in producing long-term behavior changes.
Consider pay-for-performance schemes. These are based upon the merit pay concept. Some evaluation of worker productivity will result in a relatively objective description of the relationship between task and performance. You want to know to what extent a particular individual is contributing to the achievement of the objectives of the organization. But you have to determine this in some way. Do we know that the sum of the objectives of the units of an organization is the same as the objectives of the whole organization? In fact we know it is not. So how can we determine from performance evaluation whether an employee's contribution is truly advancing the organization's movement toward success?

How do you separate individual contribution from team contribution?
How do you make it fair or at least appear fair?
How do you avoid invidious competition among individuals?
How do you avoid goal displacement?
Besides, in most organizations merit pay is almost automatic. Also, there has been much criticism of the idea of certain kinds of incentives:

"Do this and you will get that," puts the emphasis on the wrong thing. It puts the emphasis on the "that" rather than the "this". Rewards often fail.

The principal-agent problem refers to the natural differences in the incentive structure of a party who contracts to have a task carried out and the party who is hired to carry it out. The principal has certain incentives in this relationship that differ from those of the agent. The principal is mainly concerned about the achievement of a task, while the agent is concerned about receiving remuneration. The principal assigns the task but may also, in the process, assign control over the sources of information that are required to assess whether the task has been carried out. The principal then assigns the task but as a result must assume responsibility for monitoring the performance of the agent. To determine whether the task is being carried out, the principal often must rely on indicators of the success of the task. The task can assume a significance second in importance to the “proxy” measures that are adopted. The agent, in contrast, develops an interest in directing behavior toward the satisfaction of these proxy measures rather than the task itself.

In the past twenty years economics theorists have placed a great deal of emphasis on these two related problems of “adverse selection” and “moral hazard” as typical of the principal-agent problem and widely characterize contract relationships. (Daniel W. Bromley, Economic Interests and Institutions: The Conceptual Foundations of Public Policy (Oxford: Basil Blackwell, 1989). The most important method for avoiding adverse selection and moral hazard problems is to maintain an interest of the agent in the achievement of the owner’s ultimate objectives. Programs of “worker participation”, “employee-ownership”, and “participatory management” are among the devices that are adopted to bring into line the interests of the agent with the objectives of the owner.

Why do Rewards Sometimes Fail?

1) Rewards punish. Coercion destroys motivation. Punishment and rewards are not opposites but function very similarly. Rewards are manipulative. When people don't get the reward they were hoping for, they feel punished.
2) Rewards distort relations. Rewards can foster a climate of social competition and jealousy. Incentive-driven employees will not ask for help when they need it. They will avert. They will be distorted.
3) Rewards ignore reasons. Is this long-term or short-term? Did the individual cheat to do it?
4) Rewards deter-risk taking. The more people are led to think about rewards, the more they prefer easy tasks. If you begin to think "how do I achieve?" and the rules are do this and you get that? Then people think about the "that", not the "this."
5) Rewards undermine interest. People begin thinking that if they are being bribed to do something, it must not be a very good thing to do. They end up thinking that their jobs are not jobs but tasks for someone else. They can lose their interest in t heir jobs; it is displaced because the are told that their interest is somewhere else and they see others competing for it.
Agency and Organizational Structure 

The most important method for avoiding adverse selection and moral hazard problems is to maintain an interest of the agent in the achievement of the owner's ultimate objectives. Programs of "worker participation", "employee-ownership", and "participatory management" are among the devices that are adopted to bring into line the interests of the agent with the objectives of the owner.

In the case of management contracts designed as an intermediate step in state divestiture, certain aspects of "principal-agent" theory apply to the way in which the state selects the managing firms and to how the state monitors the compliance of the firms with the government's ultimate objective-the transition to private ownership. Private sector profit sharing is a way of distributing the gains within the group. For instance, a unit claims that the personnel are overworked. They want to hire a new worker. You can offer a choice, would you rather hire a new person or use the same amount of money to increase salaries of the individuals in the unit?