Assignment 1: Principal-agent Relationship

Assignment 1: Principal-agent Relationship

Critically examine the essential elements of a principal-agent relationship

If you own a small business and have to hire the services of a contractor or an outside expert, you enter into a principal-agent relationship. Trust is the key element of this relationship. Specifically, you trust that you and a contractor have the same set of incentives. A conflict of incentives leads to the principal-agent problem, this is a very common phenomenon studied in microeconomics.

The principal-agent relationship

The principal-agent relationship is an agreement between two or more individuals. Specifically, the agent interface performs a task on behalf of the principal. This is often due to different degrees of knowledge and skills. For example, if you hire a contractor to fix your roof, you are the principal, while the carpenter is the agent. You do not have the skills to perform roof repair, so you hire someone who has. Other examples may include hiring a lawyer, consulting a doctor or the advice of a bank manager. Central to the principal-agent relationship is the concept of trust. When hiring a contractor to fix your roof, you trust that he will provide the best service in your ability. Carpenter, on the other hand, is confident that will pay you once the work is complete.

Introducing Utility

In economics, utility is the satisfaction individuals receive from consumption of goods and services. Everyone experiences some level of utility from consuming a particular good, and that the difference between the utility of the people is the result of different preferences. While economists utility measure is difficult to assign a value as preferences are qualitative and not quantitative. In other words, there is no rule for measuring utility. With regard to the principal-agent relationship, utilities come in the form of incentives. The carpenter has an incentive to fix your roof, because he knows you will pay it. On the other hand, you have an incentive to pay the carpenter, because you are confident that he will fix your roof.

The principal-agent problem

The principal-agent problem arises when the incentives of the principal and agent are in direct conflict. Both the principal and agent strive to maximize their utility, but in doing so, either the principal or the agent becomes worse as a result. Let's say you pay your roofer per hour. By doing this, the carpenter realizes that, taking as much time as possible, he could reap greater rewards ...