Principal agent relationship example

Principal–agent problem - Wikipedia

principal agent relationship example

Agent: A person who agrees to act on behalf of and instead of his or her principal, subject to the principal's control. A good example would be an insurance. The principal–agent problem, in political science and economics occurs when one person or Common examples of this relationship include corporate management . "Examples of principals and agents include bosses and employees. A principal-agent relationship is often defined in formal terms described in a contract. For example, when an investor buys shares of an index.

principal-agent relationship

These have been used constructively in the past, particularly in manufacturing. More generally, however, even within the field of objective performance evaluation, some form of relative performance evaluation must be used.

principal agent relationship example

Typically this takes the form of comparing the performance of a worker to that of his peers in the firm or industry, perhaps taking account of different exogenous circumstances affecting that.

The reason that employees are often paid according to hours of work rather than by direct measurement of results is that it is often more efficient to use indirect systems of controlling the quantity and quality of effort, due to a variety of informational and other issues e.

This means that methods such as deferred compensation and structures such as tournaments are often more suitable to create the incentives for employees to contribute what they can to output over longer periods years rather than hours. These represent "pay-for-performance" systems in a looser, more extended sense, as workers who consistently work harder and better are more likely to be promoted and usually paid morecompared to the narrow definition of "pay-for-performance", such as piece rates.

This discussion has been conducted almost entirely for self-interested rational individuals. In practice, however, the incentive mechanisms which successful firms use take account of the socio-cultural context they are embedded in FukuyamaGranovetterin order not to destroy the social capital they might more constructively mobilise towards building an organic, social organization, with the attendant benefits from such things as "worker loyalty and pride Whilst often the only feasible method, the attendant problems with subjective performance evaluation have resulted in a variety of incentive structures and supervisory schemes.

One problem, for example, is that supervisors may under-report performance in order to save on wages, if they are in some way residual claimants, or perhaps rewarded on the basis of cost savings.

principal agent relationship example

Another problem relates to what is known as the "compression of ratings". Two related influences—centrality bias, and leniency bias—have been documented Landy and FarrMurphy and Cleveland The former results from supervisors being reluctant to distinguish critically between workers perhaps for fear of destroying team spiritwhile the latter derives from supervisors being averse to offering poor ratings to subordinates, especially where these ratings are used to determine pay, not least because bad evaluations may be demotivating rather than motivating.

However, these biases introduce noise into the relationship between pay and effort, reducing the incentive effect of performance-related pay.

Milkovich and Wigdor suggest that this is the reason for the common separation of evaluations and pay, with evaluations primarily used to allocate training. Finally, while the problem of compression of ratings originates on the supervisor-side, related effects occur when workers actively attempt to influence the appraisals supervisors give, either by influencing the performance information going to the supervisor: Tournaments[ edit ] Much of the discussion here has been in terms of individual pay-for-performance contracts; but many large firms use internal labour markets Doeringer and PioreRosen as a solution to some of the problems outlined.

Here, there is "pay-for-performance" in a looser sense over a longer time period. There is little variation in pay within grades, and pay increases come with changes in job or job title Gibbs and Hendricks See the superstar article for more information on the tournament theory.

Workers are motivated to supply effort by the wage increase they would earn if they win a promotion. Some of the extended tournament models predict that relatively weaker agents, be they competing in a sports tournaments Becker and Huselidin NASCAR racing or in the broiler chicken industry Knoeber and Thurmanwould take risky actions instead of increasing their effort supply as a cheap way to improve the prospects of winning.

These actions are inefficient as they increase risk taking without increasing the average effort supplied. A major problem with tournaments is that individuals are rewarded based on how well they do relative to others. Co-workers might become reluctant to help out others and might even sabotage others' effort instead of increasing their own effort LazearRob and Zemsky This is supported empirically by Drago and Garvey Why then are tournaments so popular?

Firstly, because—especially given compression rating problems—it is difficult to determine absolutely differences in worker performance. Tournaments merely require rank order evaluation. Secondly, it reduces the danger of rent-seekingbecause bonuses paid to favourite workers are tied to increased responsibilities in new jobs, and supervisors will suffer if they do not promote the most qualified person. Thirdly, where prize structures are relatively fixed, it reduces the possibility of the firm reneging on paying wages.

As Carmichael notes, a prize structure represents a degree of commitment, both to absolute and to relative wage levels.

principal agent relationship example

Lastly when the measurement of workers' productivity is difficult, e. Tournaments also promote risk seeking behavior. In essence, the compensation scheme becomes more like a call option on performance which increases in value with increased volatility cf.

If you are one of ten players competing for the asymmetrically large top prize, you may benefit from reducing the expected value of your overall performance to the firm in order to increase your chance that you have an outstanding performance and win the prize. In moderation this can offset the greater risk aversion of agents vs principals because their social capital is concentrated in their employer while in the case of public companies the principal typically owns his stake as part of a diversified portfolio.

Successful innovation is particularly dependent on employees' willingness to take risks. In cases with extreme incentive intensity, this sort of behavior can create catastrophic organizational failure. If the principal owns the firm as part of a diversified portfolio this may be a price worth paying for the greater chance of success through innovation elsewhere in the portfolio.

If however the risks taken are systematic and cannot be diversified e. Deferred compensation[ edit ] Tournaments represent one way of implementing the general principle of "deferred compensation", which is essentially an agreement between worker and firm to commit to each other. Under schemes of deferred compensation, workers are overpaid when old, at the cost of being underpaid when young.

Salop and Salop argue that this derives from the need to attract workers more likely to stay at the firm for longer periods, since turnover is costly. In other words, there is no "ruler" for measuring utility. With regard to the principal-agent relationship, utilities come in the form of incentives. The roofer has an incentive to fix your roof because he knows that you will pay him.

On the flip side, you have an incentive to pay the roofer because you are confident that he will fix your roof. The Principal-Agent Problem The principal-agent problem arises when the incentives of the principal and agent conflict.

Principal-Agent Problem

Both the principal and agent strive to maximize their utility, but by doing so, either the principal or the agent becomes worse off as a result. Let's say that you pay your roofer by the hour.

Principal-agent problem (BSE)

By doing so, the roofer realizes that, by taking as much time as possible, he could reap a higher reward in the form of money. You are powerless to prevent this, as you know little about repairing a roof. Although the roofer has fixed your roof, you end up paying more than necessary.

Principal-Agent Relationship

Eliminating the Problem Turning back to the example of the roofer, let's say that you change an element to the roofing contract. Instead of paying the roofer by the hour, you pay him by the project, a set fee.

This way, you have eliminated the roofers incentive to extend the project as long as possible. Eliminating the principal-agent problem comes down to finding the conflict of incentives. If you eliminate the conflict, you eliminate the problem.