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Principal Agent Theory Essay

There are many settings in which one economic actor (the principal) delegates authority and/or responsibilities to an agent to act on his behalf. The primary reason for doing so is that the agent has an advantage in terms of expertise or information. This informational advantage, or information asymmetry, poses a problem for the principal—how can the principal be sure that the agent has in fact acted in her best interests? Can a contract be written defining incentives in such a way that the principal can be assured that the agent is taking just the action that she would take, had she the information available to the agent?

Solving this problem is a matter of some concern for patients dealing with their doctors, clients dealing with their lawyers, etc. It is also a crucial concern for business firms dealing with their employees. Especially in the twenty-first century, employees are often hired precisely because they have information available that is unavailable to the managers of a firm, who changes or implements new ways of work (Innovation), making sure that employee expertise is put to work in the interest of the firm can make the difference between success and bankruptcy–as illustrated by the performance of Google Corporation and their success.

Principal-Agent Theory

The key common aspect of all those contracting settings is that the information gap between the principal and the agent has some fundamental implications for the design of the bilateral contract they sign.

In order to reach an efficient use of economic resources, this contract must elicit the agent´s private information. This can only be done by giving up some information rent to the privately informed agent. Generally, this rent is costly to the principal. This cost or payment is what is known as Monitoring Cost, on which the Principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent (Jensen, 1976, pg. 5).

And just like in any other trade, the Principal is giving something in exchange of the actions and decisions of the Agent; we can say that the Monitoring Cost is an action with its own reaction:Bonding Cost. This is the Welfare the Agent is willing to take, on behalf of the Principal, to limit or restrict his own actions, therefore reducing the deviation from the Principal’s interests. These costs guarantee that the Agent will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions (Jensen, 1976, pg. 5).

Nevertheless there will always be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal. The equivalent of the reduction in welfare experienced by the principal as a result of this divergence is what we refer as the Residual Loss (Jensen, 1976, pg. 5).

But as said on the beginning, this deal is because of a lack of information or expertise of the Principal in comparison with the Agent. This lead us to the Asymmetrical relationship. Asymmetrical relationship refers to the fact that the Agent may have more information than the Principal, leading to the fact that the Principal may not know to what degree are the actions of the Agent in the Principal’s own interests. Given the self-interest of the Agent, he may or may have not behaved as agreed (Eisenhardt, 1989, 61). Information is asymmetric because the agent, of course, knows which decision he is going to make (Spremann, 1987, pg. 4).

This Asymmetrical relationship leads into a field of risk and uncertainty represented by the dilemma of Moral Hazard and Adverse Selection.

Moral hazard is a situation where the behavior of one party may change to the detriment of another after the transaction has taken place. A party makes a decision about how much risk to take (Agent), while another party bears the costs if things go badly (Principal), and the party insulated from risk behaves differently than how it would if it were fully exposed to the risk. According to contract theory, moral hazard results from a situation in which a hidden action occurs. Bengt Holmström (1979) said this: It has long been recognized that a problem of moral hazard may arise when individuals engage in risk sharing under conditions such that their privately taken actions affect the probability distribution of the outcome.

The non-observability of the agent’s action may then prevent an efficient resolution of this conflict of interest since a contract can never stipulate which action should be taken by the agent. In a moral hazard context, the random output aggregates the agent’s effort and the realization of pure luck. However, the principal can only design a contract based on the agent’s observable performance. Through this contract, the principal wants to induce, at a reasonable cost, a good action of the agent despite the impossibility to condition directly the agent’s reward on his action. In general, the non-observability of the agent’s effort affects the cost of implementing a given action.

Moral hazard can be divided into two types when it involves asymmetric information (or lack of verifiability) of the outcome of a random event: Ex-Ante Moral and Ex-Post Moral. An ex-ante moral hazard is a change in behavior prior to the outcome of the random event, whereas ex-post involves behavior after the outcome. For example, in the case of a health insurance company insuring an individual during a specific time-period, the final health of the individual can be thought of as the outcome. The individual taking greater risks during the period would be ex-ante moral hazard whereas lying about a fictitious health problem to defraud the insurance company would be ex-post moral hazard.

However, there is a second type of informational asymmetry which can also characterize principal-agent relationships. Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, risk management, and statistics. It refers to a market process in which undesired results occur when buyers and sellers have. This is where the agent possesses some information prior to choosing an action which, if known by the principal, would influence the choice of action he would like the agent to make. The agent is then required to pass some message to the principal which depends on the ‘private information’ he has. Since the chosen effort, outcome and payoff to the agent may all depend on the message he transmits, the agent may have an incentive to misrepresent his information. The design of the contract will then have to take account of this problem of ‘adverse selection’.

It is important to stress that, as adverse selection, moral hazard would not be an issue if the principal and the agent had the same objective function. Crucial to the agency cost arising under moral hazard is the conflict between the principal and the agent over which action should be carried out.

Managing Innovation.

First of all we have to define what is innovation. An Innovation is a new idea, which may be a recombination of old ideas, a scheme that challenges the present order, a formula, or a unique approach which is perceived as new by the individuals involved (Zaltman, Duncan, and Holbek 1973; Rogers 1982). As long as the idea is perceived as new to the people involved, it is an “innovation,” even though it may appear to others to be an “imitation” of something that exists elsewhere. Included in this definition are both technical innovations (new technologies, products, and services) and administrative innovations (new procedures, policies, and organizational forms).

Even though innovation is always progress, it does not mean that can fit on everyone or that everyone will be happy applying it, and more because it involves changes.

When we are talking about innovation in an enterprise, managers have to deal with 4 problems. This problems are reflected in a variety of questions the CEOs often raised (Van de Ven 1982).: 1. How can a large organization develop and maintain a culture of innovation and entrepreneurship? 2. What are the critical factors in successfully launching new organizations, joint ventures with other firms, or innovative projects within large organizations over time? 3. How can a manager achieve balance between inexorable pressures for specialization and proliferation of tasks, and escalating costs of achieving coordination, cooperation, and resolving conflicts?

From these questions we can find three of four different factors that related to the Principal-Agent Theory, as Google did and we will explain it, to succeed in the implementation of innovation.First, there is the human problem of managing attention, second, the process problem is managing ideas into good currency so that innovative ideas are implemented and institutionalized, and finally there is the structural problem of managing part-whole relationships, which emerges from the proliferation of ideas, people and transactions as an innovation develops over time.

It is often said that an innovative idea without a champion gets nowhere. People develop, carry, react to, and modify ideas. People apply different skills, energy levels and frames of reference (interpretive schemas) to ideas as a result of their backgrounds, experiences, and activities that occupy their attention. People become attached to ideas over time through a social-political process of pushing and riding their ideas into good currency, much like Donald Schon (1971) describes.Schon also states that what characteristically precipitates change in public policy is a disruptive event which threatens the social system.

Here is where the Principal enters, because he needs the new ideas, so he makes a deal (contract) with the Agent to get those ideas. He (Agent) needs to respect and fulfil the contract previously made, incurring the bonding costs, so think or adapt ideas. In some way, the Principal or the contract is the pressure who makes the Agent work.

A more realistic view of innovation should begin with an appreciation of the physiological limitations of human beings to pay attention to non routine issues, and their corresponding inertial forces in organizational life (Van de Ven and Hudson 1985).

This make us think on the psychological aspect of the human being. You can implement innovation in your company or to your life (or someone else), it will be a new thing and our attention will be all focused on it.

But when exposed over time to a set of stimuli that deteriorate very gradually, people do not perceive the gradual changes- they unconsciously adapt to the worsening conditions. Suddenly we lose our focus on the innovation and we just keep doing the same routine without even thinking why.

Organizational structures and systems serve to sort attention. They focus efforts in prescribed areas and blind people to other issues by influencing perceptions, values, and beliefs. Janis (1985) states that only the vigilance pattern generally leads to decisions that meet the main criteria for sound decision making. Vigilance involves an extended search and assimilation of information, and a careful appraisal of alternatives before a choice is made. Here is where the Leader enters, setting the way where all efforts should go to.

Most of the times, these directions go around the customers needs or wishes, and the manager materialize them into the new goals, ideas or direction of the innovation.In Principal- Agent language, here is where we can find the monitoring cost, the Principal pay attention into the actions of the Agent and corrects if necessary, in case that the actions of the Agent go in a different direction as they had stipulate on the contract.

Proliferation of ideas, people, and transactions over time is a pervasive but little understood characteristic of the innovation process, and with it come complexity and interdependence – and the basic structural problem of managing part- whole relations.

Transactions are “deals” or exchanges which tie people together within an institutional context. The relationship between the Principal and the Agent is a deal, a transaction. As the Principal wants a result but can not produce it by himself, puts him in the position of a transaction.

The prevailing approach for handling this complexity and interdependence is to divide the labor among specialists (Agents) who are best qualified to perform unique tasks and then to integrate the specialized parts to recreate the whole.

The objective, of course, is to develop synergy in managing complexity and interdependence with a deal design where the whole is greater than the sum of its parts, where both of them obtained what they were looking for.

In search of that correct synergy, John R. Commons (1951), argued that transactions are dynamic and go through three temporal stages: negotiations, agreements, and administration. The deal between Principal- Agent has to be very flexible to succeed this, without being vague and confusing.

Following Ashby’s (1956) principle of requisite variety, learning is enhanced when a similar degree of complexity in the environment is built into the organizational unit. This principle is a reflection of the fact that both parts are dependant of the other (the main reason of the Principal- Agent relationship) but also a reflection of the need of being in the same ground of information, or at least on the same conditions of it (if not, there would be no deal and no need of each other). With this point and Management of Attention, the Principal can avoid and solve the problems and risk of Moral Hazard and Adverse Selection.

Google case

Talking about innovation and implementation, we can see Google. Google is the place to work according to Fortune magazine, which listed the top 50 companies to work for. Google appears as a top contender for most features, including unusual perks, cafeterias, health cover and work environment. Even Management guru Gary Hamel praised Google in his book The Future of Management, stating that more companies should adopt their system.

The system ensures that interesting ideas—even those that aren’t obvious fits for Google’s capabilities or core business model—receive some degree of attention. Their management have 3 statements and the base of all of it: First, set and communicate clear criteria for how you make funding decisions. Make sure those criteria include quantitative elements (how big could the market be) and qualitative elements (how passionate are we about this). Second, create an “ideal” innovation portfolio that blends core improvements and new growth businesses. Finally, consciously seek ideas that provide “unique” diversification by using a new channel, reaching a new customer, or creating a new revenue stream.

Every developer has 20% of their time to work on any project they want, free time if you want to see it like that, but they have also to fulfil some goals, achievements and chores. they have freedom, but still, have some responsibilities that have to accomplish. Developers have to report to their managers that they had finished all of those chores. As long as they keep doing that, the deal or transaction still valid.

About those 20% of free time, everything the developers creates, is property of the company, and still have to be approved by his manager, but have a complete freedom of the way of working and develop it.

In exchange of that intellectual currency, Google give their employees not only their salary, but also a lot of benefits and rewards. For example Google offers include 100% health care coverage and onsite childcare facilities, also a rule at Google is that no staff member should ever be further away than 100 feet from a source of food. That doesn’t mean that they only have access to vending machines with junk food, or that the cafeterias give out quick, easy and grease-laden meals. Chefs of the highest calibre prepare range of meals, with unique variations on everyday meals. Macaroni and cheese, for instance, comes with wild mushrooms and truffles.

In Google we see that the Principal-Agent and Innovation Management concepts and ideas applied.

First of all, we have to begin with the need of the Principal, the motor of the transaction. Google needs to keep on the market via innovations and new products. To fulfil those needs, Google hires new development engineers, the Agents, to create those innovations. As Bonding Cost, Google offers the engineers a payroll and to take care of their life needs, such as health, food and, in some cases, housing as an equivalent of their intellectual currency.

There is no way to eliminate the Residual Loss, but in Google they try to have the smallest one. They know they are asking a lot, but give a lot as well. As an example of that, Google tries to increase the welfare of their agents at all time more than any other company in the world, by giving them a greater payroll (incentive or Bonding cost) as exchange of actions, decisions and innovations that favors both parts.

We can see here the vigilance that the Principal has over his Agent, the Principal does not have a total control over the Agent, but gives him some chores to do to keep him on track and to keep his ideas flowing. This vigilance or monitoring is what we can see as Monitoring Cost.

Talking about Moral Hazard and Adverse Selection, Principal and Agent are always on the same track and in a lot of communication, making their bond flexible and healthy. As we said earlier, when both Principal and Agent have the same objective function, Moral Hazard and Adverse Selection, are not an issue.

Great part of their success is because they understood for who are they working for: themselves. Google hires young people, not only because their potential and innovative ideas, but also because young people are the greatest part or their market. Young people working and developing tools for young people. Who understands better their needs as themselves!

Conclusion

Innovation is the goal of every enterprise and person in this world: we were born to improve in any moment. And even though, it is very difficult to create it or implement it.

Thankfully, the Principal-Agent help us understand how some part of the human relationships work and how we can keep a healthy staff and also to remunerate them truly.

Also it is important to denote that is impossible to know at all the time what the Agent is doing or going to do, but if you create the correct synergy, and set goals that will benefit both parts, the risk of a bad decision and therefore, the vigilance, can be almost eliminated and an ambience of trust is built.

Something that surprise me it’s the fact that being in the same situation for a long time doesn’t helps the Innovation, when normally one thinks that this will create experience and knowledge enough to know how to change the method or create a new one to make it better.

Bibliography

Jean-Jacques Laffont & David Martimort; 2001;The Theory of Incentives:The Principal-Agent Model. Merton H. Miller; Kevin Rock;1985; Dividend Policy under Asymmetric Information; The Journal of Finance, Vol. 40, No. 4. (Sep., 1985), pp. 1031-1051. Ray Rees; 1985; THE THEORY OF PRINCIPAL AND AGENT:PART 2; Bulletin of Economic Research 37:2;1985. Andrew H. Van de Ven; 1986; Central Problems in the Management of Innovation; Management Science, Vol. 32, No. 5, Organization Design (May, 1986), pp. 590-607. Michael C. Jensen,William H. Meckling; 1976; Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.

Kathleen M. Eisenhardt; 1989; Agency Theory: An Assessment and Review. Klaus Spremann; 1987; Agency Theory, Information, and Incentives; pp. 3-38. Bengt Holmstrom; 1979; Moral Hazard and Observability; The Bell Journal of Economics, Vol. 10, No. 1, (Spring, 1979), pp. 74-91. Zaltman G., Duncan R., Holbek J; 1973; Innovations and Organizations. Rogers E.; 1982; Diffusion of
Innovations.

Schon D.;1971; Beyond the Stable State.
Janis I., Groupthink; 1982; “Sources of Error in Strategic Decision Making,” in J. Pennings (ed.), Strategic Decision Making in Complex Organizations, Jossey-Bass, San Francisco, 1985. Commons J.;1951; The Economics of Collection Action.

Ashby W. R.; 1956; An Introduction to Cybernetics.


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