8.5 Agency Problems

The principal-agent problem is an important subcategory of moral hazard that involves postcontractual asymmetric information of a specific type. In many, nay, most instances, principals (owners) must appoint agents (employees) to conduct some or all of their business affairs on their behalf. Stockholders in joint-stock corporations, for example, hire professional managers to run their businesses. Those managers in turn hire other managers, who in turn hire supervisors, who then hire employees (depending on how hierarchical the company is). The principal-agent problem arises when any of those agents does not act in the best interest of the principal, for example, when employees and/or managers steal, slack off, act rudely toward customers, or otherwise cheat the company’s owners. If you’ve ever held a job, you’ve probably been guilty of such activities yourself. (We admit we have, but it’s best not to get into the details!) If you’ve ever been a boss, or better yet an owner, you’ve probably been the victim of agency problems. (Wright has been on this end too, like when he was eight years old and his brother told him their lemonade stand had revenues of only $1.50 when in fact it brought in $10.75. Hey, that was a lot of money back then!)

Monitoring helps to mitigate the principal-agent problem. That’s what supervisors, cameras, and corporate snitches are for. Another, often more powerful way of reducing agency problems is to try to align the incentives of employees with those of owners by paying efficiency wagesWages higher than the equilibrium or market clearing rate. Employers offer them to reduce agency problems, hoping employees will value their jobs so much they will try to please owners by behaving in the owners’ interest., commissions, bonuses, stock options, and the like. Caution is the watchword here, though, because people will do precisely what they have incentive to do. Failure to recognize that apparently universal human trait has had adverse consequences for some organizations, a point made in business schools through easily understood case stories. In one story, a major ice cream retailer decided to help out its employees by allowing them to consume, free of charge, any mistakes they might make in the course of serving customers. What was meant to be an environmentally sensitive (no waste) little perk turned into a major problem as employee waistlines bulged and profits shrank because hungry employees found it easy to make delicious frozen mistakes. (“Oh, you said chocolate. I thought you said my favorite flavor, mint chocolate chip. Excuse me because I am now on break.”)

In another story, a debt collection agency reduced its efficiency and profitability by agreeing to a change in the way that it compensated its collectors. Initially, collectors received bonuses based on the dollars collected divided by the dollars assigned to be collected. So, for example, a collector who brought in $250,000 of the $1 million due on his accounts would receive a bigger bonus than a collector who collected only $100,000 of the same denominator (250/1,000 = .25 > 100/1,000 = .10). Collectors complained, however, that it was not fair to them if one or more of their accounts went bankrupt, rendering collection impossible. The managers of the collection agency agreed and began to deduct the value of bankrupt accounts from the collectors’ denominators. Under the new incentive scheme, a collector who brought in $100,000 would receive a bigger bonus than his colleague if, say, $800,000 of his accounts claimed bankruptcy (100/[1,000 – 800 = 200] = .5, which is > 250/1,000 = .25). Soon, the collectors transformed themselves into bankruptcy counselors! The new scheme inadvertently created a perverse incentive, that is, one diametrically opposed to the collection agency’s interest, which was to collect as many dollars as possible, not to help debtors file for bankruptcy.

In a competitive market, pressure from competitors and the incentives of managers would soon rectify such mishaps. But when the incentive structure of management is out of kilter, bigger and deeper problems often appear. When managers are paid with stock options, for instance, they are given an incentive to increase stock prices, which they almost invariably do, sometimes by making their companies’ more efficient but sometimes, as investors in the U.S. stock market in the late 1990s learned, through accounting legerdemain. Therefore, corporate governance looms large and requires constant attention from shareholders, business consulting firms, and government regulators.

A free-rider problem, however, makes it difficult to coordinate the monitoring activities that keep agents in line. If Stockholder A watches management, then Stockholder B doesn’t have to but he will still reap the benefits of the monitoring. Ditto with Stockholder A, who sits around hoping Stockholder B will do the dirty and costly work of monitoring executive pay and perks, and the like. Often, nobody ends up monitoring managers, who raise their salaries to obscene levels, slack off work, go empire-building, or all three!http://www.investopedia.com/terms/e/empirebuilding.asp This governance conundrum helps to explain why the sale of stocks is such a relatively unimportant form of external finance worldwide.

Governance becomes less problematic when the equity owner is actively involved in management. That is why investment banker J. P. Morgan used to put “his people” (principals in J.P. Morgan and Company) on the boards of companies in which Morgan had large stakes. A similar approach has long been used by Warren Buffett’s Berkshire Hathaway. Venture capital firms also insist on taking some management control and have the added advantage that the equity of startup firms does not, indeed cannot, trade. (It does only after it holds an IPOOffering of stock to investors with the aid of an investment bank. or direct public offering [DPOOffering of stock to investors without the aid of an investment bank.]). So other investors cannot free-ride on its costly state verification. The recent interest in private equity, funds invested in privately owned (versus publicly traded) companies, stems from this dynamic as well as the desire to avoid costly regulations like Sarbanes-Oxley.http://www.sec.gov/info/smallbus/pnealis.pdf

Government regulators try to reduce asymmetric information. Sometimes they succeed. Often, however, they do not. Asymmetric information is such a major problem, however, that their efforts will likely continue, whether all businesses like it or not.