Week 25: Principal-Agent Problems

Moral hazard, adverse selection, information asymmetry causing problems left, right and center. 


What are principal-agent problems?

Principal–agent problems occur when I (the "agent") make decisions on behalf of, or that impact, you (the "principal"). For example, think of your lawyer (the agent) recommending that you start what will likely be a protracted and expensive proceeding; you can’t be sure whether they’re recommending it because it’s in your best interests, their best interests, or both. All they need is a small personal stake in the outcome, and asymmetric information (where the agent has more knowledge than the principal), and you’ve got yourself a good old fashioned rodeo principal-agent problem.

Examples of principal-agent problems

In economics, moral hazard occurs when one person takes more risks because someone else bears the cost of those risks. You take out health insurance, and because someone else is responsible if you’re injured, you decide to pick up BASE jumping. There’s also adverse selection in who takes up the insurance in the first place - those more likely to need the insurance (who are already sick) are more likely to take it up.

When governments, central banks or other institutions decide to bail out lending institutions, this can encourage risky lending in the future. This happens if those that take the risks come to believe that they will not have to carry the full burden of potential losses.

If you look a little closer you’ll see that principal-agent problems crop up a lot when one person employs another. Because managers cannot have complete information of performance, good management involves aligning the interests of the employee with their performance, through potential shares, bonuses, and promotions. In the service sector, for example, managers often use tipping as a strategy to align the interests of the workers (waiters etc.) with those of the owners or managers. They have an incentive to provide good customer service (thus benefiting the company), because this makes it more likely that they will get a good tip.

Your doctor faces principal-agent problems too. In deciding what treatment you need, they also have a personal stake in some outcomes because they earn more with more treatment, and it would be between very surprising and I’m-not-sure-we’re-in-Kansas-anymore surprising if they never acted to in their own self-interest.

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