Agency Problems and Incentives

Kevin Hinde

Aims

In this session we will analyse the meaning of the agency problem within organisations.

And note how the following can alleviate the problem via– Performance contracts for individuals and

teams.– Hierarchical structures

The Agency Relationship

An agency relationship exists when one party, the Principal, contracts another party, the agent, to perform some service on the Principal’s behalf.

Examples Employer and Employee Shareholders and managers Regulators and regulated Politicians and civil servants

Note that there can be multi-agent and multi-principal relationships

Note the similarities with stakeholder analysis.

The problem

Agents do not perform for the principals because they have conflicting objectives.

Examples – The objectives of politicians may be electoral success not

maximising the ‘public interest’ for the minimum taxpayers dollar.

– Employees may be interested in maximising their income for the minimum effort rather than the maximum effort required by their employer.

In other words we face a Moral Hazard problem again.

A solution for individual agents

Through performance related contracts.– Usually this is via payment systems and requires that the

contract has 2 elements Make the individual participate in the contract given the

uncertain state of the environment. THE PARTICIPATION CONSTRAINT.

Give the agent the incentive to engage in high levels of effort once they have agreed to participate in the contract. THE INCENTIVE COMPATIBILITY CONSTRAINT. (Remember that this is important because effort is a cost to an individual)

– Note though that money alone cannot often induce agents to act in the interests of the principal(s).

A solution for teams

Most productive activity is carried out by teams. However,

There must be potential synergies for working as a team.

Team members must either have or be able to acquire at low cost (to the organisation) the relevant specific knowledge for making good decisions.

The organisation must be able to control the free-rider problems of teams at a relatively low cost.

A solution for teams

What factors determine optimal team size?– Depends upon a mixture of

Agency issues. The ability to control the free rider problem. Knowledge of the team. More team members = more

knowledge. Productivity. An additional member can be more productive

but eventually diminishing returns sets in.

The optimal team size can vary between 2 and 25 according to research by Katzenbach J R and Smith D K (1993) The Wisdom of Teams, Harvard Business School.

Some Interesting Team payments

Forcing Contracts. – These specify that the workers meet a certain

target that is easy to monitor. If the target is not met then the employer pays the workers nothing. This will increase the effort levels. However, it crucially depends on the extent to which trust exists between the principal and the agents.

Some Interesting Team payments

Efficiency Wages. – Here employees motivate workers by paying above the

opportunity (reservation) wage and have inspectors monitor job performance at random intervals. If shirking occurs, then the employee is fired on the spot. Clearly, monitoring costs the firm so employees must balance the costs of getting caught shirking on the job with the potential gains from a higher wage.

Revenue/Profit Sharing. Here revenue or profit is shared equally. Sadly, this gives

rise to a classic prisoner’s dilemma – all will defect in the absence of incentives to cooperate.

Hierarchies and the assignment of decision rights

Benefits of specialised task assignment Exploiting comparative advantage. Lower cross-training expenses. Relative ease of motivating workers to perform a narrower set

of tasks.

Costs of specialised task Assignment Lost complementarities from performing few functions. Functional myopia. Reduced flexibility. Incentive issues (blame can be easily apportioned)

Choosing the type of hierarchy is important. Divisional (geographic/product), Matrix form, etc.