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The Principal-Agent Problem

Principal - Agent

In each of these little scenarios on the previous page, there are some common features. On the one hand, you have a buyer and on the other, someone or some organisation who is a seller. In each case, the seller and the buyer have access to information and in each case, the information that exists between the two is either not clear or is difficult to understand and/or interpret - in other words, it is what we would call 'imperfect information'.

Perfect Competition

If you turn to any economics textbook, you are likely to find a description of 'perfect competition'. Perfect competition exists when the following characteristics are in place in a market:

• Free entry and exit to industry
• Homogenous product - identical so no consumer preference
• Large number of buyers and sellers - no individual seller can influence price
• Sellers are price takers - the have to accept the market price
• Perfect information available to buyers and sellers

The last item here - perfect information - is one of the keys to the existence of perfect competition. When the theory of perfect competition is introduced in most classrooms, it does not take many minutes for students to recognise that there are some issues with this theory. Most of the characteristics of perfect competition simply do not exist in the real world and it would be very hard to imagine a situation where every buyer and seller in a market knew everything about each other.

Information is rarely perfect; in many cases, we are dealing with situations where one person or organisation has some knowledge that the other party does not have. In such circumstances, what is the effect on the working of the market? Copyright: Alistair Williamson, from stock.xchng.

The reality is that most people have very limited knowledge about the products and services that we buy. Equally, it could be argued that sellers only have limited access to what consumers really want - market research is rarely perfect or totally representative. What exists in most markets, therefore, is imperfect information.

The lack of knowledge in a market can often cause market failure. It is not only that we do not know enough about products, services and prices, we also do not know what the motivation and incentives are of those who might be offering us those goods and services. Is the TV sales person at Curry's giving me an objective and unbiased assessment of the TVs they have for sale? Do they really believe that the extended warranty that they are offering me at the checkout really does represent value for money, or are there other reasons for them trying to sell me a Toshiba TV and an associated extended warranty?

What about the doctor? How do I know that the diagnosis s/he has made is really accurate and worse still, how do I know that the treatment they are suggesting is the best for me? Are they suggesting treatment x because they have some form of self interest?

Asymmetric Information

The problems that arise when one individual to an economic decision has different information to that of another is called 'asymmetric information'. It is a specific aspect of imperfect information in markets.

The problems that imperfect information bring to economic decision making is fairly obvious in many respects but perhaps not something that we really think about too much or lend weight to in the average economics lesson in schools. In reality, it affects millions of decisions every day. The importance of this in economic theory has been given a greater degree of weight in recent years. In theory, and assuming perfect competition, both parties to an exchange would be acting for their own interests but would also be aware of the basis on which the other was operating. The resulting exchange would benefit both parties to an equal degree. The examples at the start of this resource shows situations where this is not the case because of imperfect information. This imperfect information, however, can take on different forms.

Principal and Agent

The two parties to an economic decision such that we have described so far can be referred to as principal and agent. There are specific issues, however, that relate to these two terms. The term 'agent' refers to a seller or organisation that has some information which is not known to the principal. In most cases, the principal is using the agent to act for them and to bring about the desired exchange.

For example, if I go to a travel agency to book a holiday, I have to rely on the information that they give me in making my decision as to the characteristics of my holiday. If they tell me that hotel x is excellent, has superb views, is quiet, peaceful and romantic with excellent food and service and is valued highly by other customers, how do I know that this is really the case? I might have suspicions that the hotel might be in the middle of a building site, be overrun by screaming kids, have less than average food, poor service and poor quality rooms.

The picture of the motel in the brochure looked so much different to how it actually turned out. How do I know what I am letting myself in for when I book my holiday? Copyright: Bob Smith, from stock.xchng.

Moral Hazard and Adverse Selection

In such cases, there might be incentives on the part of the agent to behave differently than would be the case if both parties had perfect information. The outcome may be less than desirable decision-making, which leads to economic inefficiency. The problems that can arise might be characterised by what are called moral hazard and adverse selection.

Moral hazard refers to cases where people who are in possession of asymmetric information, and where the accuracy of the information they possess cannot be monitored or challenged, have an incentive to behave differently - either in a dishonest way or in a way that might not provide the full benefit to the principal.

Moral hazard also has implications for the agent but in a different way. For example, I have an extensive house insurance policy that covers everything in my house. My insurance company expects me to take every possible precaution to ensure the safety of my personal possessions. However, because I know I am fully covered, I might not be as careful as I might otherwise be. I might leave a window open in the summer, forget to put the alarm on and even leave the door unlocked. My behaviour is affected by the existence of the insurance and the insurance company simply has no way of checking to make sure that I behave in a totally responsible manner at all times.

Carelessness on my part might contribute to a break in at my house - but not to worry, everything is insured. How can the insurance company encourage me to behave in a more responsible manner? Copyright: Hilary Quinn, from stock.xchng.

Adverse selection refers to cases where asymmetric information leads to goods and services being bought and sold that are not of the quality expected. The selection by either the seller or the buyer is adverse.

Quality comes at a price - doesn't it? Copyright: Sergio Ianni, from stock.xchng.

This might be linked to the idea that 'you get what you pay for'. If I go to a local DIY retailer to look at buying a new drill, I am faced with quite a selection. I look at the branded names and they are all very expensive, they don't look all that different and have very similar specifications. I look at the cheapest drills and come to the conclusion that the retailer would not be selling rubbish so go for the cheap drill. Three weeks later the thing breaks down - I should have known!

The problem for the manufacturers of recognised brands is that they have difficulty convincing buyers that their product is really worth paying the extra for. They are forced to reduce their prices to compete with the cheaper products, but this is often not commercially viable. In the end, they might give up producing in that market altogether.

Oranges and Lemons

The importance of the principal agent problem in economics can be highlighted by the fact that in 2001, three economists - George Akerlof, Michael Spence and Joseph Stiglitz - were awarded the Nobel Prize in Economics for their contribution to the problem.

Akerlof's award was for his 1970 essay entitled "The Market for Lemons". This is a brief summary of the problem he explored.

Akerlof used the market for used cars as the basis for his explanation. In this market, the seller has information about the car that the buyer does not have. The seller might know the history of the car and details about how it was driven, whether it has been involved in any accidents and so on. This is a clear case of asymmetric information. Akerlof suggested that there would be two types of cars in the market: good cars, which we will refer to as oranges, and bad cars, which he called 'lemons'. If I go to buy a second hand car from a dealer, I do not know whether the dealer is selling me an orange or a lemon. I might be willing to pay a reasonable price to buy an orange but I am clearly not willing to pay that same price to buy a lemon. The seller, however, knows whether the car they are trying to sell me is a lemon or an orange. If the seller presents me with a 'nice little runner', therefore, as a buyer I have to consider whether it is an orange or a lemon. In effect, there is a probability of 0.5 that it will be one or the other. The existence of asymmetric information in a market such as the one for used cars is likely to mean that most for sale will be 'lemons'. Why would anyone want to sell a 'good' car in the first place? Copyright: Melvin Green and Steve Woods, both from stock.xchng. Given that I have imperfect information, I simply do not know whether the car I am buying is an orange or a lemon. To get an orange, I might have to pay £10,000. The seller on the other hand, who has a lemon for sale, will be prepared to accept almost anything to get rid of it. Let's say that he is willing to accept £4,000 for it. If I offer the seller £4,000 for the car he is trying to sell me and it is a sure-fire orange, he will laugh me out of the showroom. As the buyer, however, I am not sure whether I want to offer £10,000 for the possibility of buying a lemon. Akerlof also raised the issue about why anyone would want to sell a good car in the first place. If I had a good car, it is highly unlikely that I would get the true value of the car paid to me. Logic would suggest that the only reason I would want to sell my existing car and buy another is because I was looking to replace a sub-standard vehicle with a better quality one. If everyone was doing that, though, would the market exist at all? The idea here can be clarified by the analogy of buying a brand new car. If I bought this Corvette and drove it out of the showroom, round the block and then back to the showroom again and asked the dealer to buy it back off me, they would pay nothing like the price I had paid to them only five minutes before. Why? Because they would assume that there was something wrong with it - why would I want to sell it otherwise? The market for used cars tends to be one dominated by sellers of lemons as those who have a good car (orange) are unlikely to sell - why would they? Image copyright: Hans Balliet, from stock.xchng. The result is that the market tends to be dominated by lemons. The seller is not willing to sell oranges for less than £10,000 but I, as the seller, am unwilling to pay that much for the chance of being sold a lemon. The conclusion that Akerlof came to was that the market in this type of scenario would only see low quality goods traded.

Akerlof extended his analysis to other areas apart from used-cars.

Medical Insurance

In the case of medical insurance (highly relevant in the United States of course), there will be a case of asymmetric information between the insurance company and the person looking to get insurance cover. The person looking for cover knows more about their personal health problems than do the insurance company who have to rely on the information they are told by the individual.

If I am looking to buy health insurance, I might be tempted to hide the extent to which I am prone to different illnesses because I know that this would force up the price of the insurance. The insurance company, in turn, will be aware that some of its potential customers are sicker than they are prepared to admit. They will put up the price of insurance premiums as a result. This acts as a deterrent to healthy people taking out medical insurance because of the high prices charged.

Older people have greater problems obtaining medical insurance than younger people. Do you know why this is? Copyright: Peter Skadberg, from stock.xchng.

Akerlof notes that the problem is especially acute for those over 65. If you want to take out medical insurance when at these advanced years, the chances are it is because you fear becoming ill and know that you will need treatment. The risk facing the insurance company of having to pay out large sums on treatment costs might mean that they force the price up. The only people that seek to pay these high prices are those that are really in need of medical attention and so the medical condition of applicants declines as the price goes up. Ultimately, Akerlof suggests that no price will persuade an insurance company to take on some individuals and so the market breaks down.

Akerlof goes on to point out that this provides a powerful argument for the provision of state-sponsored health care, but that then presents other problems!

The Labour Market

Akerlof suggested that the employment of minorities might be affected by asymmetric information. In this case, belonging to a particular ethnic group might tell an employer something about the educational and social background of the applicant. When an individual applies for a job, the employer is not sure whether he is seeing someone who is able to do the job or whether they are not worth employing. Akerlof suggested this was not a case of prejudice but pure profit maximisation. An employer might be reluctant to place someone in a responsible position when they were unable to distinguish between "those with good job qualifications and those with bad qualifications". As a result employment of people from these communities may be lower than those from other communities and lead to a cycle of difficulties and poverty.

Solutions

The problem of asymmetrical information is easily solved - improve the quality of the information between the two parties to the exchange.... Ok, that's solved that problem. Now lets move on to another!

Of course, if it was that simple then it really would be a case of moving on to another problem. In reality, the solution, while obvious, is not quite as easy to bring about. Improving the quality of information available to buyers and sellers is a feature of many jobs that have been created in the last 20 years. We live in the so-called 'information age' and the development of computer technology does mean that we have access to information at greater levels than ever before. Sometimes, though, this is still not enough and in some cases, can merely exacerbate the problem.

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