Question

A few years ago, the Boston Globe reported that the city of Boston planned to spend $14 million to convert the FleetCenter sports arena and entertainment center into an appropriate venue for the Democratic National Convention (DNC). The city engaged Shawmut Design and Construction in a contractual relationship to complete the work, which was supposed to start 48 days prior to the commencement of the DNC on July 26. However, when negotiations between Boston’s mayor and the police union broke down, the Boston Police Patrolmen’s Association took to the picket lines surrounding the FleetCenter and prevented construction crews from beginning the work. The Globe reported that “a truck attempting to deliver steel turned around after a crowd of union members stood at a chain-link gate in front of the arena, shouting ‘back it up,’ and ‘respect the line, buddy.’” Moreover, the Globe reported that “On-duty police officers, who had been instructed to prevent pickets from restricting access, did not intervene.” Given the tight construction schedule, construction delays reportedly cost about $100,000 per day.

Identify the principal–agent problem in this situation. Did the mayor and the city of Boston face the classical “hold-up problem” or another problem? Explain.

Answer 1

Answer:

The difference or inequality of information between the lenders and the buyers in financial markets is known as "Asymmetric information".

There exists asymmetric information because the manager of a firm does not have any incentive to maximize the welfare or profits of the shareholders and they act in their own interests. This is known as "principal-agent" problem.

This problem occurs when the owners do not have complete information about the behaviour or motive of their managers.

Principal-agent problem arises when an agent(a party) agrees to work in favour of the principal(another party) in exchange for some incentives. A contractual agreement between them might lead to a huge cost for the agent, which further leads to problem of moral hazard and conflict of interest.

Moral-hazard is a problem of asymmetric information. An individual gets involved in a riskier investment or a riskier event knowing they are protected against the risk, where someone else bears the costs.

Conflicts of interest between the owners and the managers aggravate the problem of asymmetric information because it becomes almost certain that the manager will act in their own interests.

In this situation, the principal-agent problem exists between on-duty police officers (the agent) and the city officials who hire them (the principals)

On-duty police officers had to stop picket lines from blocking access of workers. Police union members engage in opportunistic behaviour to improve their bargaining power.

The city has committed $14 million to host the DNC and the police union has attempted to take advantage of this specialized investment. Therefore, the city is facing the "hold-up problem"

There is a problem of written contractual agreement. When the city of Boston got into a contract with Design and Construction firm, there were many unforeseeable events that were not explicitly defined.

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