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What Is the Principle-Agent Relationship? Using Examples from the...

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What Is the Principle-Agent Relationship? Using Examples from the Public Sector Explain Why Inefficiencies May (or May Not) Arise Because of a Principle-Agent Relationship. Is There a Way to Resolve Any Problems?

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  • Jan. 2011
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A great majority of social and economic relationships are of the principle agent type. The principle-agent problem is a game-theoretic situation where; there is a player (the principal) and one more other players (the agents). This is the problem of how the principle can motivate the agent to act for the principles benefit rather than follow self interest. “The problem is how to devise incentives which lead to report truthfully to the principle on the facts they face and the actions they take, and act for the principles benefit. Incentives include rewards such as bonuses or promotion for success, and penalties such as demotion or dismissal for failure to act in the principles interest.” (Black, J. 2003). The actions however, may not always be apparent so it is not usually adequate for the principle to state payment on the actions of the agents. The reasons why we expect the public sector to be inefficient has to do with the incentives and restrictions of the individual and organisational levels. There are at least two important reasons why perfect contingency markets have not developed as stated by Broadway & Wildasin (1984). The first reason is that the transaction costs of establishing such markets might be high relative to the number of traders. The other reason is the observable fact of asymmetric information, also known as the principal agent problem. Two particularly significant consequences of this reliance are “moral hazard” and “adverse selection”. Daniel W. Bromley (1989), states that the principal must rely on indicators of success rather than success itself (adverse selection), while the agent directs attention toward the satisfaction of proxy measures rather than toward the success of the task itself. (moral hazard).

The “hazard” in moral hazard refers to the fact that the individual has an incentive to direct behaviour toward proxy measures rather than toward the desired goal. This redirection can result in creating incentives for perverse...