Structure of Principal-Agent Models

Structure of Principal-Agent Models:

1) Environment, Constraints and Equilibrium

As with all economic models, we must specify preferences and opportunities, including the production environment. Given these, we can specify the efficient allocation of resources, based on Pareto optimality. This is usually referred to as the first-best solution.

The Elements of the Agency Problem:

(a) We have the preferences of both the principal and the agent.

(b) Typically we have a production function, which relates the actions of the agent to something valued by the principal.

(c) There’s as well a participation or reservation utility constraint. Transactions must be voluntary, so here the principal must attract the agent. In standard models, this might take the form of paying the competitive price.

(d) There’s also a contract linking the principal to his agent, which enumerates payments from the principal to the agent in various states.

(e) There are incentive compatibility constraints. The agent doesn’t do what he’s told or even what he says he’ll do. He does what is in his interest to do, given the incentives the principal gives him.

(f) The principal chooses a compensation contract, which specifies what the agent is to do and what he will be compensated based on each observable outcome, to maximize his own objective subject to the constraints that the agent accepts the contract and the specified actions be incentive compatible.

2) The Efficiency Wage Theory:

A theory that firms pay wages above the equilibrium level in order to prevent workers from shirking. Of course, it is irrational for other companies to pay fixed wage lower than their competitor’s level, so we would expect that all other companies would also offer a wage similar (or same) to their competitor’s level.

3) Franchising:

An alternative ownership is franchising, in which a franchisor, such as McDonald’s Corporation , sells the right to open outlets under its trademark to independent entrepreneurs called franchisees. Typically, the franchisee pays the franchisor a fixed franchise fee plus a royalty based on sales. One of the advantages of franchising over company ownership is that franchisees have a strong incentive to run their outlets as active owner-managers who attempt to prevent workers from shirking. Franchise chains typically begin with one or a few company owned outlets in one geographic area, so initially the owners are able to effectively monitor workers and deter shirking. As a chain expands beyond a few outlets in one region, however, it becomes increasingly difficult for the owners to monitor each outlet. One possible solution is to hire high-quality managers to prevent shirking, but rapid expansion makes it difficult to find high-quality managers. Furthermore, managers have an incentive to shirk themselves, so managerial oversight is likely to be moderately successful at best. Franchising has become a common method of trying to reduce the principal-agent problem associated with rapid chain expansion.

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