Lecnotes14 - ECON 696 Managerial Economics and Strategy...

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ECON 696: Managerial Economics and Strategy Lecture Notes 14: Agency and Performance Measurement Introduction If there is one chapter in this book which you should read, it is this one. This was sort of left to the end of the course just to make sure you look at all the other material, too. This chapter describes the principal-agent problem , which describes any situation in which the owner of a firm hires someone to work for her and delegates some responsibility to that person. The owner of the firm, the principal , wants the person she hires, the agent , to perform in a certain way. The agent, on the other hand, has preferences that make him want to act in a different way. This is the principal-agent problem. Solving the problem means coming up with an arrangement that makes the agent's incentives as much like the principal's as possible. Several solutions to this problem have been proposed and are widely used, but none is perfect and the problem is pervasive. The Agency Relationship An agency relationship exists any time a principal hires an agent to do something. In this relationship, it is the principal who bears the risk and generally has a right to the profits from the relationship. A university might hire a professor to teach a set of classes. The university is the principal in that they take the risk that tuition paid by the students taking the class may not cover the professor's salary, but if many students take the class there may be a significant amount of profit made on the course. That same professor may have a consulting business and may hire a student to do some calculations for him. In this relationship, the professor is the principal because it is, perhaps, his reputation with his client that will benefit or suffer from the quality of the agent's calculations. If you hire a real estate agent to help you with the sale of your home, you are the principal because after the sale is concluded you get to keep any resulting profit. The real estate agent, as the title suggests, is the agent. The seller would like the agent to work hard to maximize the price for which a house is sold. However, the standard contract under which real estate agents work specifies that the agent receives only a small percentage of the sales price, meaning that if the agent works extremely hard to increase the sales price of the house, she will likely receive only a tiny portion of the additional value that she has generated for the principal. As a result, it is commonly believed that
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agents prefer to market houses in ways that assure a quicker sale, with less effort by the agent, and yielding a lower selling price than the seller (the principal) would prefer. (For further discussions of this, you might look at Freakonomics : A Rogue Economist Explores the Hidden Side of Everything by Steven D. Levitt and Stephen J. Dubner and Naked Economics: Undressing the Dismal Science by Charles Wheelan.) Economists often refer to the principal as the residual claimant in the relationship,
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Lecnotes14 - ECON 696 Managerial Economics and Strategy...

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