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Agency Problems and

Incentives

Kevin Hinde
Aims

 In this session we will analyse the meaning


of the agency problem within organisations.
 And note how the following can alleviate the
problem via
– Performance contracts for individuals and teams.
– Hierarchical structures
The Agency Relationship
 An agency relationship exists when one party, the
Principal, contracts another party, the agent, to
perform some service on the Principal’s behalf.
 Examples
 Employer and Employee
 Shareholders and managers
 Regulators and regulated
 Politicians and civil servants

 Note that there can be multi-agent and multi-


principal relationships
 Note the similarities with stakeholder analysis.
The problem
 Agents do not perform for the principals because
they have conflicting objectives.
 Examples
– The objectives of politicians may be electoral success not
maximising the ‘public interest’ for the minimum
taxpayers dollar.
– Employees may be interested in maximising their income
for the minimum effort rather than the maximum effort
required by their employer.
 In other words we face a Moral Hazard problem
again.
A solution for individual agents
 Through performance related contracts.
– Usually this is via payment systems and requires that the
contract has 2 elements
 Make the individual participate in the contract given the
uncertain state of the environment. THE PARTICIPATION
CONSTRAINT.
 Give the agent the incentive to engage in high levels of effort
once they have agreed to participate in the contract. THE
INCENTIVE COMPATIBILITY CONSTRAINT. (Remember that
this is important because effort is a cost to an individual)
– Note though that money alone cannot often induce agents
to act in the interests of the principal(s).
A solution for teams

 Most
productive activity is carried out by
teams. However,
 There must be potential synergies for working as a
team.
 Team members must either have or be able to acquire
at low cost (to the organisation) the relevant specific
knowledge for making good decisions.
 The organisation must be able to control the free-rider
problems of teams at a relatively low cost.
A solution for teams
 What factors determine optimal team size?
– Depends upon a mixture of
 Agency issues. The ability to control the free rider problem.
 Knowledge of the team. More team members = more
knowledge.
 Productivity. An additional member can be more productive
but eventually diminishing returns sets in.
 The optimal team size can vary between 2 and 25
according to research by Katzenbach J R and
Smith D K (1993) The Wisdom of Teams, Harvard
Business School.
Some Interesting Team payments

 Forcing Contracts.
– These specify that the workers meet a certain
target that is easy to monitor. If the target is not
met then the employer pays the workers
nothing. This will increase the effort levels.
However, it crucially depends on the extent to
which trust exists between the principal and the
agents.
Some Interesting Team payments
 Efficiency Wages.
– Here employees motivate workers by paying above the opportunity
(reservation) wage and have inspectors monitor job performance
at random intervals. If shirking occurs, then the employee is fired
on the spot. Clearly, monitoring costs the firm so employees must
balance the costs of getting caught shirking on the job with the
potential gains from a higher wage.
Revenue/Profit Sharing.
Here revenue or profit is shared equally. Sadly, this gives rise to a
classic prisoner’s dilemma – all will defect in the absence of
incentives to cooperate.
Hierarchies and the assignment of
decision rights
 Benefits of specialised task assignment
 Exploiting comparative advantage.
 Lower cross-training expenses.
 Relative ease of motivating workers to perform a narrower set of
tasks.
 Costs of specialised task Assignment
 Lost complementarities from performing few functions.
 Functional myopia.
 Reduced flexibility.
 Incentive issues (blame can be easily apportioned)

 Choosing the type of hierarchy is important.


 Divisional (geographic/product), Matrix form, etc.

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