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The Principal-Agent Problem: Solutions

Signals

To work effectively, markets rely on signals. Improving the quality of the signal that exists within a market should help to reduce asymmetric information. This signalling takes the form of finding ways to enable the person or group with the privileged information to somehow convey that information to the uninformed party. This might be done in any of the following ways:

  • Advertising
  • Branding
  • Specialising in providing information
  • Regulation
  • Provision of incentives to encourage appropriate and desirable behaviour

In the case of the first two, the intention by a firm, for example, is to try and persuade the prospective customer that what they are saying they are offering really is an orange and not a lemon! The hope would be that once the customer has trusted the firm to provide a good quality good or service (orange) that they will come back and repeat purchase. The probability of them buying a lemon has been reduced. Advertising and branding are both expensive and time consuming. Improving the signals to reduce asymmetric information is not cheap therefore.

Poster for the show Dirty Dancing outside a theatre in London

Adverts have a variety of functions, one of which is to try and convey important information about quality and reliability - if you do come and see this show, you will not be disappointed. The comment at the bottom of this poster is a quote from a review of the show, which tries to confirm that it is not just the theatre that thinks it is good but other people too - you can trust the information being given! Copyright: Biz/ed team.

Many firms now specialise in providing information which prospective buyers can use to base their decision making. Firms like Mintel exist to provide 'intelligence' about a wide range of markets and businesses. The research it carries out can be bought or commissioned by other firms and can help to reduce the asymmetry of information. Such market intelligence does not come cheap, however!

Regulation in the UK often includes some way in which the regulator provides information to the tax payer to help in their decision making. A very good example is in education and health. Both these vital public services are subject to checks, inspection, grading and league tables. In so doing, the express aim is to help patients and parents make more informed choices. If you want to know whether the school your child is going to is an orange (the school will no doubt tell you that it is) then read the Ofsted report which will help you to be able to get a 'truer' picture. If you want to check your hospital, look at the star ratings it is given by the Social Services Inspectorate.

Providing incentives to avoid the problems of moral hazard has been used in the labour market. Employers do not necessarily know whether their employees are working as hard or as effectively as they say they are. It does not make sense, therefore, for an employer to pay the whole of the remuneration package to an employer at the outset. Part of it can be kept back until a later date, possibly in the form of an end of year bonus payment when there is evidence that the employee has actually been doing the work they claim!

Incentives to behave appropriately can also be enforced in the form of legislation. There are laws, for example, for the conduct of solicitors, accountants, surveyors, plumbers, stock brokers and so on. This is meant to encourage those in such professions where the asymmetry of information could be significant to avoid behaving in a way that could lead to moral hazard.

Screening

A second way of trying to improve the problems caused by asymmetrical information is something called screening. In this case, the principal (assumed to have less information) takes some form of steps to try and encourage the agent (who has the information) to reveal more about what they know. In so doing, the principal is in a better position to be able to make a more informed decision.

In the case of Akerlof's lemons, if I do intend buying a second hand car I can employ the services of the AA or the RAC to check over the car for me and tell me whether it really is what the dealer is telling me it is. In other cases, interviews and formal application forms where applicants for a post are asked to divulge specific pieces of information which can often be checked might be a way of reducing the asymmetry of information in the labour market. In medical insurance or other forms of life assurance, the insurance company may ask for a medical report from a doctor to be provided before cover is offered.

Summary

Much of the content of economics assumes rational behaviour and perfect knowledge. Markets may not work efficiently not only because information is not perfect but because information is asymmetric - one person having access to better information than another. The greater the degree of asymmetry, the greater the tendency to moral hazard and adverse selection.

When Akerlof first presented his paper on lemons for publication, it was rejected as being based on too simplistic an example. Another rejection stated that if he was right, it would turn economics on its head. In many respects, this is exactly what it has done: it has opened up the field to analysis that incorporates rational behaviour and human failings, such as the work of game theorists and the likes of Daniel Kahneman, a Nobel Prize winner for economics in 2002. Kahneman looked at cognitive behavioural theories in decision making in economics. His main argument focused on the fact that humans don't always make purely rational choices - decisions are also affected by the extent to which people are risk averse or risk seeking.

In any decision, there is the potential for the parties to the decision - the principal and the agent - to experience a gain or a payoff. The payoff could be positive but might also be negative. The risk involved in achieving the payoff will also be a factor that might impact on the eventual decision made.

We can see that a number of strands of economic thinking are coming together, which might help us to better understand the working of markets that we observe in everyday life. This could help put in place things that would make markets work more effectively in allocating resources. The principal agent problem has many applications and it is something worth factoring into your A' level studies and answers when relevant.

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