Examination of Principal-Agent Theory - Essay Example

Principal-Agent theory Introduction Principal-agent theory is a model based in economics that monitors the means entailed in the dealings between a buyer (principal) and seller (agent). This interaction has been widely used in the political sphere primarily in studies of the US Congressional system (Cohen, 1). As Lane indicates, the analysis of multifaceted private contracting initiated the development of the principal-agent theory. A difference can be made between temporary contracting as with the buying and selling of goods on the one hand and continuing contracting on the other hand whereby an individual hires another individual or group of individuals to work for them against compensation (2). A principal-agent correlation is a contract in which one or more individuals appoint another individual to carry out some service on their behalf whereby the former is the principal and the later is the agent. This entails entrusting some decision making power to the agent which is fairly common. For instance, a homeowner (principal) may employ a carpenter (agent) to repair her table while a client (principal) may hire a lawyer (agent) to defend his case. Principal-agent correlations also normally arise within organizations, even though the above two examples describe relations in a private setting. In organizations, the role of the principal is often played by the board of directors, which contracts a manager to manage the institution in the interest of the investors or in the interest of the stakeholders in the case of a nonprofit organization (Caers et.al, 26). Principal-agent theory is used to portray a dyadic relation between a buyer and a seller. At its most basic levels, this model originated from economics. In this relationship the buyer makes a deal with the seller and has the finances to acquire the seller’s service of the service. This means that the buyer has the control required to fund and realize the service that they require. Conversely, the seller can push the association to their favor and increase the price since they have more knowledge concerning the service they are providing than the buyer does. However, either the seller or buyer can employ this to their benefit depending on phrasing of the contract. Principal-agent theory assumes that the seller and the buyer do not yearn for a jointly beneficial result of the association, but would somewhat pay less or charge more than what the other is offering (Cohen, 5) In a principal-agent interaction at least two people are to partner in the formation of a service that has value. However, the two individuals are not of the same legal standing or partners. The agent is the individual who works for the principal while the principal puts up the payment for agent’s effort against the value that the agent gives to the principal in the form of a product of some sort. Consequently, principal-agent interaction is basically an agreement on how much of the value that the agent produces should go back to him/her as an earning. Nevertheless, what makes the principal-agent model unique is the extra assumption of asymmetric information, meaning that the agent knows more than the principal about the service under consideration in a manner that may influences the contracting results (Lane, 2). In the principal-agent model, the payoff to the principal relies on an action taken by the agent. The principal cannot contract for the action, but can pay off the agent founded on some evident sign that is associated with the action. The first mover is the principal who decides an incentive system for paying the agent depending on the apparent sign. On the hand, the agent decides the best action to take, given the incentives, and then chooses whether to accept the principal’s offer, based on the estimated payment and the prejudiced cost of carrying out the action. Upon agreeing, the agent decides an action that makes the most of his remunerations and the principal monitors the signal associated with the action and pays the agent in line with the incentive system while receiving a payoff dependent upon the sign. (Allison, 163). The relation between the nonprofit board of directors (the principal) and its manager (the agent) is the first internal principal-agent relationship. There appear to be little agreement about how both parties relate to each other in this relationship; empirical agency and theoretical literature remain fairly thin. However, literature does exist concerning board behavior (Caers et.al, 32). The first internal principal-agent relationship in acting as an agent, the manager will probably need to employ employees who will assist him to perform the jobs set by the board and who may or not pursue interests that match to his own. Therefore, the manager becomes the principal in the principal-agent relationship between himself and the employees. Consequently, managers are both principal and agent, depending on the relationship that is regarded (Caers et.al, 41). Principal-agent theory means that the principal can by no means get the upper hand except he is ready to consider substitute agents. As a result, he must create some type of bidding or competition between agents and have the chance of ending the relationship. Assessment or supervising will only help in so far as it creates probable contractual options to existing agreements (Lane, 10). Lane asserts that the typical examples of principal-agent relationships consist of the defendant-lawyer, the insurance company-the insured, the patient- doctor and the landlord-tenant interactions. However, the employment contract may as well be considered as principal-agent interaction, which makes the model appropriate to the understanding of the managers’ problem of choosing and encouraging CEOs to carry out large scale enterprises. Incorporated in the area of application of the principal-agent model is also the alleged teams’ problem of arranging a team of people accountable for the mutual production of an output (2). In addition, the principal-agent interaction can be considered as any effort to produce something bearing a certain possibility of failure. The principal presumes the major burden of risk in the principal-agent framework, being risk neutral while the agent is mainly risk avert. If not, the agent might make himself the principal (3). Principal-agent theory demands that diverse kinds of contracts and optional rules of the game must be used so that the principal may have results. The usual forms of agreement between government and bureaucracy only strengthen the information advantage of the agent: development of a unique expertise, long-term contracting and incremental budget-making (Lane, 10). Financiers cannot anticipate maintaining the right to control decisions not specified in advance, in a world of incomplete contracts. These alleged “residual rights of control” usually end up with managers since financiers are generally either not adequately informed or not qualified to choose what to do in the area of daily operations. The group’s problem is born here and the reason why a company’s governance is an everyday concern (Salter, 8). The principal-agent approach has over the past decade or so become definitely the leading approach to the study of delegation in comparative, domestic, and international politics. The principal-agent approach draws from rational-choice theories of international and domestic politics, arguing that influential rational performers i.e. voters or legislators at the domestic level, states at the international level, hand over powers to executive and judicial agents systematically so as to reduce the transaction costs of policy-making, and as a result they modify the prudence of their agents. Subsequently, the original act of delegation, some principal-agent accounts continue to make forecasts about the independence and authority of executive and judicial agents, which are usually theorized to differ as a function of the administrative and oversight methods available to the principals (Pollack, 1). principal-agent analysts make the hidden assumption that agents seek to avoid injunction by their principals at all costs, they may well be mistaken, and the judicial realm particularly replete with subjective examples of judges translating constitutional or statutory law in accordance with their legal convictions, and provoking the legislature to overturn that decision through new legislation if they disagree (Pollack, 4). A considerable advantage of this relationship exists for firms when they have better access to explicit knowledge concerning market opportunities and risks compared to either their competitors or other financial stakeholders in the market. Moreover, firms benefit when their build up experience effects in well-tested viable notions or theories enabling a resourceful and efficient use of firm resources. Such acquaintance can effect in the development of extremely productive work structures, the plan and manufacture of advanced products or the lessening of risk through precise forecasting. This will ultimately help to reduce excessive control or monopoly of particular firms in the market (Salter, 10). Leruth & Paul states that principal-agent correlations can incorporate a number of government processes. For instance, one could deem that the minister heading the line ministry is a principal whose purpose is to ensure that his/her agents (the civil servants) execute what he/she has assured to do. Another consideration is that the parliament, whose goal is to ensure that the executive executes the government’s program, is the principal. However, another instance would be to consider the sub national governments as the agents while the central government is the principal (5). Lane adds that under the principal-agent design, the government can use different types of agents, from diverse forms of in-house production to different forms of out-house production (5). The division of the financing and management of firms produce the agency problem. Suppliers of assets of course want to be certain that managers will be functioning in their concerns and providing sufficient returns when they invest in a business undertaking. In a straightforward world, financiers could be guaranteed of such outcomes by signing a clear-cut contract specifying how managers should utilize the invested funds and how the profits are to be shared between both parties. In the actual world however, it is complex to describe and forecast all future possibilities, thereby creating an imperfect contract between financiers and managers. For this reason, the principle agent theory should be applied to solve this control problem by the managers. This will create an enabling environment whereby the investors are very confident when they invest with particular firms (Salter, 8). Considering the agency theory, disjointing of control and ownership gives rise to agency costs, which deteriorate performance of firms. There is a substantial risk that company resources will not be used in the quest of shareholder earnings. This is because the interests of management (agents) need not and usually do not correspond with those of possessors (principals). Due to this, there need to be a consistent means of control over managerial performance by company shareholders (Kuznetsov & Muravyev, 3). Another limitation of the theory is the fact that worldwide organizations for instance the European Court of Justice or the European Commission have sovereign inclinations and can influence political results in their own right but are not sheer agents of their political majors. In addition, it is assumed that principal-agent analyses have some prejudice in describing the significance of the agent. Moreover, principal-agent analyses wipe out the likelihood of agents enjoying independence and influence from their principals. These assertions demonstrates that the principal agent theory do not fully overcome the problem of control and ownership in firms and organizations (Pollack, 3). Another more comprehensible limitation of the theory is that majority of principal agent analyses make shortening suppositions concerning the inclination or preference of agents, frequently assuming that they are preference outliers along some pertinent facet of policy. A good example is in the case of monetarists at central banks or more commonly budget or proficiency-maximizers (Pollack, 4). Identifying an observable that will be the major constituent of the contract is a vital element of any principal-agent model. Measuring performance ought to supremely be founded on a blend of pointers including impact, result and production when the agent is the line ministry. Although it is frequently the only variable for which sufficient data are obtainable, such information is typically hard to attain (Leruth & Paul, 5) The principal-agent theory presents a new viewpoint upon government and firms in the pursuit of overcoming the problems of ownership and control. Its power is demonstrated when government is considered as the principal searching for agents to implement and realize its policies. This model can also be applied in interactions involving doctor and patient, lawyer and defendant and landlord and tenant. However, the principal-agent model is weak on explaining societal objectives and trust, which figure outstandingly in the public sphere. The theory also has some limitations in making assumptions in the preference of agents, wiping out their autonomy and in considering international organizations as agents. Work Cited Allison, Mose. Principal-Agent Models. 2010. Web. Caers, Ralf. et al. “Principal-Agent Relationships on the Stewardship-Agency Axis” Nonprofit Management & Leadership 17.1 (2006): 25-47. Print. Cohen, James. “Application of Principal-Agent Theory to Security Sector Reform.” Journal of security sector management 7.2 (2009): 1-17. Print. Kuznetsov, Pavel & Muravyev, Alexander. Ownership Structure and Firm Performance in Russia: The Case of Blue Chips of the Stock Market. 2001. Web. Lane, Jan-Erik. Relevance of the Principal-Agent Framework to Public Policy and Implementation. 2003. Web. Leruth, Luc. & Paul, Elisabeth. “A Principal-Agent Theory Approach to Public Expenditure Management Systems in Developing Countries.” OECD Journal on Budgeting 7.3 (2007): 1-29. Print. Pollack, Mark. A. Principal-Agent Analysis and International Delegation: Red Herrings, Theoretical Clarifications, and Empirical Disputes. 2006. Web. Salter, Malcolm. S. “Notes on Governance and Corporate Control.” Journal of Strategic Management Education 1.1(2003): 5-54. Print. Read More