Principal-Agent Relationship

The principal-agent model represents situations in which a supervisor (principal) delegates a task to a supervisee (agent) who has specialized knowledge about the task but also has objectives that are different from those of the principal. This is what occurs, for example, between an employer and an employee, between legislators and bureaucrats, between regulators and regulated firms, between voters and public officials in a representative [Page 533]democracy, and between managers and stockholders. In such situations the principal cannot directly accomplish some specific tasks and needs to delegate them to the agent, who acts on behalf of the principal. The agent has superior private information that can be of two types. If the agent has superior information regarding the characteristics of some goods (e.g., their quality) or one or more of his or her own characteristics that are relevant to the task (e.g., skills, preferences, honesty), then the principal faces a problem of adverse selection. If the agent can take actions (e.g., the effort exercised in pursuing the task or the act of accepting a bribe from a third party to underperform) that are unobserved by the principal, then the problem is moral hazard. Because of the conflicting interests, the agent has to be compensated in order to be induced to act according to the principal's preferences. The principal's problem is therefore to design a contract that selects the right type of agent (to solve adverse selection problems) or that provides the agent with the right incentives, that is, induces the agent to act according to the principal's objective (to solve moral hazard problems). This process goes under the name of mechanism design.

In the absence of asymmetric information, the principal and the agent could stipulate a contract in which the payment for the agent is made contingent on the actions or type of actions of the agent. This would be the first best outcome. With asymmetric information, however, the problem is more complex, and it will usually be impossible to reach the first best. Asymmetric information induces an agency cost because providing the right incentives to the agent is costly. This is a special form of transaction cost that only allows the players to reach the second best, an outcome that is Pareto-dominated by the first best but that can be considered optimal given the added informational constraint faced by the principal.

When there is adverse selection, agents of the “good” type can try to convey information on their quality (or the quality of the products they try to sell) by acquiring a costly signal (signaling). Alternatively, the principal can propose a menu of contracts, trying to infer the quality of the agents from their choice of contract (screening). In any event, agents of inferior quality have an incentive to mimic the behavior of better agents. The problem is illustrated by Michael Spence in 1973 in a signaling model of the labor market in which education is used as a signaling device by workers with (innate) high skills. Education levels work as a signal of skill only if education is more costly to acquire for less skilled individuals. This assumption is also known as the Spence-Mirrlees condition, or single-crossing property, because the indifference curve (in this case mapping in a wage-education diagram) of the low-ability worker (or, in general, of the seller of bad products) crosses the corresponding curve of the high-ability worker once from below. In other words, a variable can be used as a signaling device only if it is manipulable by individuals and if we can expect it to be related in the right way (i.e., it is more easily obtained by good types) with the characteristic of interest. Two kinds of equilibria can emerge. In a separating equilibrium all workers with high productivity choose an education level that is higher than that chosen by less productive workers. Firms pay a higher wage (corresponding to workers' anticipations) to people with a higher education, correctly assuming that they have higher productivity. In a pooling equilibrium, all workers have the same education level and get the same wage. The outcome depends on the distribution of skills among workers, on the costs of education, and on the beliefs of agents.

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