✎✎✎ Principal Agent Theory

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Principal Agent Theory

But the agent will be liable if he is undisclosed or partially disclosed, if the agent lacks authority principal agent theory exceeds it, principal agent theory, of course, if the principal agent theory entered into the principal agent theory in a personal principal agent theory. As a general rule the line principal agent theory demarcation principal agent theory an independent contractor and a servant is not clearly principal agent theory. An agent principal agent theory not usurp an opportunity from the principal by taking principal agent theory for himself principal agent theory passing it on to a third party. Contract-theoretic principal—agent models have been principal agent theory in principal agent theory fields, including financial contracting, [38] regulation, principal agent theory public procurement, [40] principal agent theory price-discrimination, [41] job design, [42] principal agent theory labor markets, [43] team production, [44] and Admiral Mcravens Speech Analysis others. Principal agent theory our article on that type of agency relationship principal agent theory California. It is principal agent theory referred principal agent theory as "usual authority" though not in the sense used by Lord Emotional Isolation In Mary Shelleys Frankenstein MR principal agent theory Hely-Hutchinsonwhere principal agent theory is synonymous with "implied actual authority". This cookie is a session cookie version principal agent theory the 'rud' Racial Discrimination In The Workplace Exercises Why is agency principal agent theory especially important in the business and government principal agent theory

Principal Agent Problem

An agent, as a general rule, is only entitled to indemnity from the principal if they have acted within the scope of their actual authority, and if they act outside of that authority they may be in breach of contract, and liable to a third party for breach of the implied warranty of authority. Express actual authority means an agent has been expressly told they may act on behalf of a principal. Implied actual authority, also called "usual authority", is authority an agent has by virtue of being reasonably necessary to carry out his express authority.

As such, it can be inferred by virtue of a position held by an agent. For example, partners have authority to bind the other partners in the firm, their liability being joint and several, and in a corporation, all executives and senior employees with decision-making authority by virtue of their position have authority to bind the corporation. Other forms of implied actual authority include customary authority. This is where customs of a trade imply the agent to have certain powers.

In wool buying industries it is customary for traders to purchase in their own names. This must be no more than necessary [3]. Apparent authority also called "ostensible authority" exists where the principal's words or conduct would lead a reasonable person in the third party's position to believe that the agent was authorized to act, even if the principal and the purported agent had never discussed such a relationship. For example, where one person appoints a person to a position which carries with it agency-like powers, those who know of the appointment are entitled to assume that there is apparent authority to do the things ordinarily entrusted to one occupying such a position.

If a principal creates the impression that an agent is authorized but there is no actual authority, third parties are protected so long as they have acted reasonably. This is sometimes termed "agency by estoppel " or the "doctrine of holding out", where the principal will be estopped from denying the grant of authority if third parties have changed their positions to their detriment in reliance on the representations made. In the case of Watteau v Fenwick , [5] Lord Coleridge CJ on the Queen's Bench concurred with an opinion by Wills J that a third party could hold personally liable a principal who he did not know about when he sold cigars to an agent that was acting outside of its authority. Wills J held that "the principal is liable for all the acts of the agent which are within the authority usually confided to an agent of that character, notwithstanding limitations, as between the principal and the agent, put upon that authority.

It is sometimes referred to as "usual authority" though not in the sense used by Lord Denning MR in Hely-Hutchinson , where it is synonymous with "implied actual authority". It has been explained as a form of apparent authority, or "inherent agency power". Authority by virtue of a position held to deter fraud and other harms that may befall individuals dealing with agents, there is a concept of Inherent Agency power, which is power derived solely by virtue of the agency relation. Even if the agent does act without authority, the principal may ratify the transaction and accept liability on the transactions as negotiated. This may be express or implied from the principal's behavior, e. If the agent has actual or apparent authority, the agent will not be liable for acts performed within the scope of such authority, as long as the relationship of the agency and the identity of the principal have been disclosed.

When the agency is undisclosed or partially disclosed, however, both the agent and the principal are liable. Where the principal is not bound because the agent has no actual or apparent authority, the purported agent is liable to the third party for breach of the implied warranty of authority. If the agent has acted without actual authority, but the principal is nevertheless bound because the agent had apparent authority, the agent is liable to indemnify the principal for any resulting loss or damage. If the agent has acted within the scope of the actual authority given, the principal must indemnify the agent for payments made during the course of the relationship whether the expenditure was expressly authorized or merely necessary in promoting the principal's business.

An agent must not accept any new obligations that are inconsistent with the duties owed to the principal. An agent can represent the interests of more than one principal, conflicting or potentially conflicting, only after full disclosure and consent of the principal. An agent must not usurp an opportunity from the principal by taking it for himself or passing it on to a third party. In return, the principal must make a full disclosure of all information relevant to the transactions that the agent is authorized to negotiate. The internal agency relationship may be dissolved by agreement.

Under sections to of the Indian Contract Act , an agency may come to an end in a variety of ways:. Further, under s. If he does, he is liable to compensate the agent for the loss caused to him thereby. The same rules apply where the agent, renounces an agency for a fixed period. Notice in this connection that want of skill, continuous disobedience of lawful orders, and rude or insulting behavior has been held to be sufficient cause for dismissal of an agent. Further, reasonable notice has to be given by one party to the other; otherwise, damage resulting from want of such notice, will have to be paid s. Under s. The termination does not take effect as regards the agent, till it becomes known to him and as regards third party, till the termination is known to them s.

This has become a more difficult area as states are not consistent on the nature of a partnership. Some states opt for the partnership as no more than an aggregate of the natural persons who have joined the firm. Others treat the partnership as a business entity and, like a corporation , vest the partnership with a separate legal personality. Hence, for example, in English law a partner is the agent of the other partners, whereas in Scots law "a [partnership] is a legal person distinct from the partners of whom it is composed" [9] and so a partner is the agent of the partnership per se. This form of agency is inherent in the status of a partner and does not arise out of a contract of agency with a principal. Even if that implied authority has been revoked or limited, the partner will have apparent authority unless the third party knows that the authority has been compromised.

Hence, if the partnership wishes to limit any partner's authority, it must give express notice of the limitation to the world. However, there would be little substantive difference if English law was amended: [10] partners will bind the partnership rather than their fellow partners individually. For these purposes, the knowledge of the partner acting will be imputed to the other partners, or to the firm if a separate personality. The other partners or the firm are the principal and third parties are entitled to assume that the principal has been informed of all relevant information.

This causes problems when one partner acts fraudulently or negligently and causes loss to clients of the firm. In most states, a distinction is drawn between knowledge of the firm's general business activities and the confidential affairs as they affect one client. Thus, there is no imputation if the partner is acting against the interests of the firm as a fraud. There is more likely to be liability in tort if the partnership benefited by receiving fee income for the work negligently performed, even if only as an aspect of the standard provisions of vicarious liability. Whether the injured party wishes to sue the partnership or the individual partners is usually a matter for the plaintiff since, in most jurisdictions, their liability is joint and several.

Agency relationships are common in many professional areas. The most cited reference to the theory, however, comes from Michael C. Jensen and William Meckling. In the context of law, principals do not know enough about whether or to what extent a contract has been satisfied, and they end up with agency costs. The solution to this information problem—closely related to the moral hazard problem—is to ensure the provision of appropriate incentives so agents act in the way principals wish.

In terms of game theory , it involves changing the rules of the game so that the self-interested rational choices of the agent coincide with what the principal desires. Even in the limited arena of employment contracts, the difficulty of doing this in practice is reflected in a multitude of compensation mechanisms and supervisory schemes, as well as in critique of such mechanisms as e. In the context of the employment contract, individual contracts form a major method of restructuring incentives, by connecting as closely as optimal the information available about employee performance, and the compensation for that performance. Because of differences in the quantity and quality of information available about the performance of individual employees, the ability of employees to bear risk, and the ability of employees to manipulate evaluation methods, the structural details of individual contracts vary widely, including such mechanisms as "piece rates, [share] options, discretionary bonuses, promotions, profit sharing, efficiency wages, deferred compensation, and so on.

The secondary sector is characterised by short-term employment relationships, little or no prospect of internal promotion, and the determination of wages primarily by market forces. In terms of occupations, it consists primarily of low or unskilled jobs, whether they are blue-collar manual-labour , white-collar e. These jobs are linked by the fact that they are characterized by "low skill levels, low earnings, easy entry, job impermanence, and low returns to education or experience. The use of tipping is a strategy on the part of the owners or managers to align the interests of the service workers with those of the owners or managers; the service workers have an incentive to provide good customer service thus benefiting the company's business , because this makes it more likely that they will get a good tip.

The issue of tipping is sometimes discussed in connection with the principal—agent theory. To sway them [ agents ], principals have to make it worth the agents' while It is a means to make people work hard. Friendly waiters will go that extra mile, earn their tip, and earn a relatively high income As a solution to the principal—agent problem, though, tipping is not perfect. In the hopes of getting a larger tip, a server, for example, may be inclined to give a customer an extra large glass of wine or a second scoop of ice cream. While these larger servings make the customer happy and increase the likelihood of the server getting a good tip, they cut into the profit margin of the restaurant.

In addition, a server may dote on generous tippers while ignoring other customers, and in rare cases harangue bad tippers. Part of this variation in incentive structures and supervisory mechanisms may be attributable to variation in the level of intrinsic psychological satisfaction to be had from different types of work. Sociologists and psychologists frequently argue that individuals take a certain degree of pride in their work, and that introducing performance-related pay can destroy this "psycho-social compensation", because the exchange relation between employer and employee becomes much more narrowly economic, destroying most or all of the potential for social exchange.

Evidence for this is inconclusive—Deci , and Lepper, Greene and Nisbett find support for this argument; Staw suggests other interpretations of the findings. Incentive structures as mentioned above can be provided through non-monetary recognition such as acknowledgements and complements on an employee agent in place of employment. Research conducted by Crifo and Diaye [18] mentioned that agents who receive compensations such as praises, acknowledgemnt and recognition help to define intrinsic motivations that increase performance output from the agents thus benefiting the principal.

Furthermore, the studies provided a conclusive remark that intrinsic motivation can be increased by utilising the use of non-monetary compensations that provide acknowledgement for the agent. These higher rewards, can provide a principal with the adequate methodologies to improve the effort inputs of the agent when looking at the principal agent theory through an employer vs employee level of conduct. On a related note, Drago and Garvey use Australian survey data to show that when agents are placed on individual pay-for-performance schemes, they are less likely to help their coworkers. This negative effect is particularly important in those jobs that involve strong elements of "team production" Alchian and Demsetz , where output reflects the contribution of many individuals, and individual contributions cannot be easily identified, and compensation is therefore based largely on the output of the team.

The negative incentive effects implied are confirmed by some empirical studies, e. Leibowitz and Tollison find that larger law partnerships typically result in worse cost containment. There is however considerable empirical evidence of a positive effect of compensation on performance although the studies usually involve "simple" jobs where aggregate measures of performance are available, which is where piece rates should be most effective.

Research shows that pay for performance increases performance when the task at hand is more repetitive, and reduces performance when the task at hand requires more creative thinking. Furthermore, [20] formulated from their studies that compensation tend to have an impact on performance as a result of risk aversion and the level of work that a CEO is willing to input. This showed that when the CEO returned less effort then the data correlated a pay level of neutral aversion based on incentives.

However, when offered incentives the data correlated a spike in performance as a direct result. Conclusively, their studies indicated business owner principal and business employees agents must find a middle ground which coincides with an adequate shared profit for the company that is proportional to CEO pay and performance. In doing this risk aversion of employee efforts being low can be avoided pre-emptively.

This essentially states that any measure of performance that on the margin reveals information about the effort level chosen by the agent should be included in the compensation contract. This includes, for example, Relative Performance Evaluation—measurement relative to other, similar agents, so as to filter out some common background noise factors, such as fluctuations in demand. By removing some exogenous sources of randomness in the agent's income, a greater proportion of the fluctuation in the agent's income falls under his control, increasing his ability to bear risk. If taken advantage of, by greater use of piece rates, this should improve incentives. In terms of the simple linear model below, this means that increasing x produces an increase in b.

However, setting incentives as intense as possible is not necessarily optimal from the point of view of the employer. The Incentive-Intensity Principle states that the optimal intensity of incentives depends on four factors: the incremental profits created by additional effort, the precision with which the desired activities are assessed, the agent's risk tolerance, and the agent's responsiveness to incentives.

According to Prendergast , 8 , "the primary constraint on [performance-related pay] is that [its] provision imposes additional risk on workers In incentive terms, where we conceive of workers as self-interested rational individuals who provide costly effort in the most general sense of the worker's input to the firm's production function , the more compensation varies with effort, the better the incentives for the worker to produce.

The third principle—the Monitoring Intensity Principle— is complementary to the second, in that situations in which the optimal intensity of incentives is high corresponds highly to situations in which the optimal level of monitoring is also high. This is because monitoring is a costly means of reducing the variance of employee performance, which makes more difference to profits in the kinds of situations where it is also optimal to make incentives intense.

The fourth principle is the Equal Compensation Principle , which essentially states that activities equally valued by the employer should be equally valuable in terms of compensation, including non-financial aspects such as pleasantness of the workplace to the employee. This relates to the problem that employees may be engaged in several activities, and if some of these are not monitored or are monitored less heavily, these will be neglected, as activities with higher marginal returns to the employee are favoured.

This can be thought of as a kind of " disintermediation "—targeting certain measurable variables may cause others to suffer. Because of this, the more difficult it is to completely specify and measure the variables on which reward is to be conditioned, the less likely that performance-related pay will be used: "in essence, complex jobs will typically not be evaluated through explicit contracts.

Where explicit measures are used, they are more likely to be some kind of aggregate measure, for example, baseball and American Football players are rarely rewarded on the many specific measures available e. The alternative to objective measures is subjective performance evaluation, typically by supervisors. However, there is here a similar effect to "multi-tasking", as workers shift effort from that subset of tasks which they consider useful and constructive, to that subset which they think gives the greatest appearance of being useful and constructive, and more generally to try to curry personal favour with supervisors.

One can interpret this as a destruction of organizational social capital —workers identifying with, and actively working for the benefit of, the firm — in favour of the creation of personal social capital—the individual-level social relations which enable workers to get ahead "networking". The four principles can be summarized in terms of the simplest linear model of incentive compensation:. The above discussion on explicit measures assumed that contracts would create the linear incentive structures summarised in the model above. But while the combination of normal errors and the absence of income effects yields linear contracts, many observed contracts are nonlinear. Similarly, the threat of being fired creates a nonlinearity in wages earned versus performance.

Moreover, many empirical studies illustrate inefficient behaviour arising from nonlinear objective performance measures, or measures over the course of a long period e. This inefficient behaviour arises because incentive structures are varying: for example, when a worker has already exceeded a quota or has no hope of reaching it, versus being close to reaching it—e. Leventis shows that New York surgeons, penalised for exceeding a certain mortality rate, take less risky cases as they approach the threshold.

Courty and Marshke provide evidence on incentive contracts offered to agencies, which receive bonuses on reaching a quota of graduated trainees within a year. This causes them to 'rush-graduate' trainees in order to make the quota. In certain cases agency problems may be analysed by applying the techniques developed for financial options , as applied via a real options framework. At the same time, since equity may be seen as a call option on the value of the firm, an increase in the variance in the firm value, other things remaining equal, will lead to an increase in the value of equity, and stockholders may therefore take risky projects with negative net present values, which while making them better off, may make the bondholders worse off.

See Option pricing approaches under Business valuation for further discussion. Nagel and Purnanandam notice that since bank assets are risky debt claims, bank equity resembles a subordinated debt and therefore the stock's payoff is truncated by the difference between the face values of the corporation debt and of the bank deposits. Jensen and William Meckling, an increase in variance would not lead to an increase in the value of equity if the bank's debtor is solvent. The major problem in measuring employee performance in cases where it is difficult to draw a straightforward connection between performance and profitability is the setting of a standard by which to judge the performance.

One method of setting an absolute objective performance standard—rarely used because it is costly and only appropriate for simple repetitive tasks—is time-and-motion studies , which study in detail how fast it is possible to do a certain task. These have been used constructively in the past, particularly in manufacturing. More generally, however, even within the field of objective performance evaluation, some form of relative performance evaluation must be used. Typically this takes the form of comparing the performance of a worker to that of his peers in the firm or industry, perhaps taking account of different exogenous circumstances affecting that.

The reason that employees are often paid according to hours of work rather than by direct measurement of results is that it is often more efficient to use indirect systems of controlling the quantity and quality of effort, due to a variety of informational and other issues e. This means that methods such as deferred compensation and structures such as tournaments are often more suitable to create the incentives for employees to contribute what they can to output over longer periods years rather than hours.

These represent "pay-for-performance" systems in a looser, more extended sense, as workers who consistently work harder and better are more likely to be promoted and usually paid more , compared to the narrow definition of "pay-for-performance", such as piece rates. This discussion has been conducted almost entirely for self-interested rational individuals. In practice, however, the incentive mechanisms which successful firms use take account of the socio-cultural context they are embedded in Fukuyama , Granovetter , in order not to destroy the social capital they might more constructively mobilise towards building an organic, social organization, with the attendant benefits from such things as "worker loyalty and pride Subjectivity is related to judgement based on a supervisor's subjective impressions and opinions, which can be expressed through the use of subjective performance measures, ex post flexibility in the weighting of objective performance measures, or ex post discretional adjustment, all of which are based on factors other than performance measures specified ex ante.

Whilst often the only feasible method, the attendant problems with subjective performance evaluation have resulted in a variety of incentive structures and supervisory schemes. One problem, for example, is that supervisors may under-report performance in order to save on wages, if they are in some way residual claimants, or perhaps rewarded on the basis of cost savings. Another problem relates to what is known as the "compression of ratings".

Two related influences—centrality bias, and leniency bias—have been documented Landy and Farr , Murphy and Cleveland The former results from supervisors being reluctant to distinguish critically between workers perhaps for fear of destroying team spirit , while the latter derives from supervisors being averse to offering poor ratings to subordinates, especially where these ratings are used to determine pay, not least because bad evaluations may be demotivating rather than motivating.

However, these biases introduce noise into the relationship between pay and effort, reducing the incentive effect of performance-related pay. Milkovich and Wigdor suggest that this is the reason for the common separation of evaluations and pay, with evaluations primarily used to allocate training. Much of the discussion here has been in terms of individual pay-for-performance contracts; but many large firms use internal labour markets Doeringer and Piore , Rosen as a solution to some of the problems outlined. Here, there is "pay-for-performance" in a looser sense over a longer time period.

There is little variation in pay within grades, and pay increases come with changes in job or job title Gibbs and Hendricks The incentive effects of this structure are dealt with in what is known as " tournament theory " Lazear and Rosen , Green and Stokey , see Rosen for multi-stage tournaments in hierarchies where it is explained why CEOs are paid many times more than other workers in the firm. See the superstar article for more information on the tournament theory.

Workers are motivated to supply effort by the wage increase they would earn if they win a promotion. Some of the extended tournament models predict that relatively weaker agents, be they competing in a sports tournaments Becker and Huselid , in NASCAR racing or in the broiler chicken industry Knoeber and Thurman , would take risky actions instead of increasing their effort supply as a cheap way to improve the prospects of winning. These actions are inefficient as they increase risk taking without increasing the average effort supplied. Neilson further added to this from his studies which indicated that when two employees competed to win in a tournament they have a higher chance of bending and or breaking the rules to win.

Nelson also indicated that when the larger the price incentive the more inclined the agent employee in this case is to increase their effort parameter from Neilson's studies. A major problem with tournaments is that individuals are rewarded based on how well they do relative to others. Co-workers might become reluctant to help out others and might even sabotage others' effort instead of increasing their own effort Lazear , Rob and Zemsky This is supported empirically by Drago and Garvey Why then are tournaments so popular? Firstly, because—especially given compression rating problems—it is difficult to determine absolutely differences in worker performance.

Tournaments merely require rank order evaluation. Secondly, it reduces the danger of rent-seeking , because bonuses paid to favourite workers are tied to increased responsibilities in new jobs, and supervisors will suffer if they do not promote the most qualified person. This effectively takes the factors of ambiguity away from the principal agent problem by ensuring that the agent acts in the best interest of the principal but also ensures that the quality of work done is of an optimal level. Thirdly, where prize structures are relatively fixed, it reduces the possibility of the firm reneging on paying wages. As Carmichael notes, a prize structure represents a degree of commitment, both to absolute and to relative wage levels.

Lastly when the measurement of workers' productivity is difficult, e. Tournaments also promote risk seeking behavior. In essence, the compensation scheme becomes more like a call option on performance which increases in value with increased volatility cf. If you are one of ten players competing for the asymmetrically large top prize, you may benefit from reducing the expected value of your overall performance to the firm in order to increase your chance that you have an outstanding performance and win the prize.

In moderation this can offset the greater risk aversion of agents vs principals because their social capital is concentrated in their employer while in the case of public companies the principal typically owns his stake as part of a diversified portfolio. Successful innovation is particularly dependent on employees' willingness to take risks. In cases with extreme incentive intensity, this sort of behavior can create catastrophic organizational failure. If the principal owns the firm as part of a diversified portfolio this may be a price worth paying for the greater chance of success through innovation elsewhere in the portfolio.

If however the risks taken are systematic and cannot be diversified e. Tournaments represent one way of implementing the general principle of "deferred compensation", which is essentially an agreement between worker and firm to commit to each other. Under schemes of deferred compensation, workers are overpaid when old, at the cost of being underpaid when young. Salop and Salop argue that this derives from the need to attract workers more likely to stay at the firm for longer periods, since turnover is costly.

Alternatively, delays in evaluating the performance of workers may lead to compensation being weighted to later periods, when better and poorer workers have to a greater extent been distinguished. Workers may even prefer to have wages increasing over time, perhaps as a method of forced saving, or as an indicator of personal development. For example, Akerlof and Katz if older workers receive efficiency wages, younger workers may be prepared to work for less in order to receive those later.

Overall, the evidence suggests the use of deferred compensation e. The "principal—agent problem" has also been discussed in the context of energy consumption by Jaffe and Stavins in They were attempting to catalog market and non-market barriers to energy efficiency adoption. In efficiency terms, a market failure arises when a technology which is both cost-effective and saves energy is not implemented.

Jaffe and Stavins describe the common case of the landlord-tenant problem with energy issues as a principal—agent problem. The energy efficiency use of the principal agent terminology is in fact distinct from the usual one in several ways. Is the agent the landlord and the principal the tenant, because the landlord is "hired" by the tenant through the payment of rent? As Murtishaw and Sathaye, point out, "In the residential sector, the conceptual definition of principal and agent must be stretched beyond a strictly literal definition.

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