Question

Economics

(a) Identify a principal-agent situation you are in or have been in. Perhaps you were the principal, designing a contract or set of rules for an employee or for one of your children. Perhaps you were the agent, being subject to a contract or set of rules designed by an employer or your parents.

(b) Identify the primary objective of the agent,

(c) identify the primary objective of the principal,

(d) explain how the principal used knowledge of the agent’s objective in designing the of the contract or set of rules.

(e) If possible, identify any unintended negative consequence of the contract or set of rules that would lead you to believe there may be a better contract or set of rules.

Answer 1

Answer a-In economics, the principal–agent problem, also known as agency dilemma or the agency problem, ooccurs when one person's decision/actions impact, another person's. Here, the person who makes the decision is called the the "agent" and the person who is affected by the decision is called the "principal". This agency problem arises in circumstances where agents are motivated to act in their own best interests, which are contrary to the interest of their principals.Common examples of principal-agent relationship include corporate management (agent) and shareholders (principal), elected members (agent) and voter citizens (principal), or brokers (agent) and buyers and sellers (principals) etc.

Let us understand this in detail by assuming two different perspectives-

1.As the principal, designing a contract or set of rules for an employee-In this situation, the employer is the 'principal' and the employee is the 'agent'. From the perspective of the principal (if I were the Principal), it will be the best interest of the principal to make sure that the employee always acts according his best interest. For this, the principal designs a contract or a set of rules so that the agent(employee) acts according to the rules that satisfies the best interest of the employer (principal). But, the principal-agent problem arises when the two parties have different interests and asymmetric information. The agent (employee) has more information regarding his time of work and method of work which the principal (employer) do not have in making the rules. Here, the principal's interest is to make agents work according to the set of rules that are useful for him but costly to the agent, similarly, the agent's interest is to choose not to enter into the contract if it pays him less and if it has a possibility of being exploited by the principal. This conflict in interest leads to the principal-agent problem. The actions useful to the principal are costly to the agent and vice-versa.

2. As the agent, being subject to a contract or set of rules designed by an employer- In this case, from the agent's perspective, if the agent has a small or nonexistent share in the outcome, he will prefer not to enter into the contract. On the other hand, the principal will try to make the agent enter into the contract if it is beneficial and gives him a optimal profit. When activities that are useful to the principal, they are costly to the agent, and also what the agent does are costly for the principal to observe, the conflict of interest occurs.

To avoid such problems, various means may be used to align the interests of the agent with those of the principal. For example- employers (principal) may use commissions, profit sharing, efficiency wages, performance measurement , or the threat of termination of employment to align worker interests with their own In this way the problem will be solved.