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 behaviour. The “adverse” in adverse selection refers to the fact that the establishment of monitoring criteria leads to perverse measurement. Individuals who wish to take out insurance possess information that insurers don’t. The insured persons (the agents) can exploit this informational advantage in dealing with insurers (the principles) in various ways (Broadway & Wildasin, 1984).
Moral hazard occurs when the insured can, through actions unobservable to the insurer, influence wither the probability of a loss occurring, or the magnitude of the loss. For example, a person can influence the probability of an accident by the degree of preventive action taken. If the quantity of preventive action is not observable to the insured, market failure can result. Alternatively the standard example of how the insured influences the size of the loss is medical insurance. In the event that illness occurs, the insured can overuse medical services. Adverse selection occurs when there are several different types of insured persons, distinguishing from one another by the probabilities of a bad state of nature occurring. Thus, for some persons might be high risk and others low risk, and the insurers cannot tell one from the other. Automobile insurers cannot tell careful from careless drivers except imperfectly through such indicators as sex, and family status. Equilibrium may not exist in the presence of adverse selection and even if it does it may not be efficient. A problem related to adverse selection is the simple lack of information by market participants. The diversification of the Pareto-Optimality of competitive markets assumed that individuals and firms have complete knowledge regarding the availability and attributes of all goods and factors. Such will not always be the case. Consumers may not know the implications of various products for their health or safety, nor will they have full information on the relative merits of various competing consumer items. Firms do not...
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