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Answer the weekly assignment questions, following guidelines. There’re 3 questions, 2 of them require short answers and one ask for a short essay that doesn’t exceed 500 words. Please check the attached materials (Assignment + class matrials), and let me know if you have a questions.
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Table of contents
1. Introduction
3
2. What is delegation?
3
3. Gains from delegation
5
4. Issues resulting from delegation
4.1 Agency slack
4.2 Moral hazard
4.3 Adverse selection
6
6
8
9
5. Solutions to the principal–agent problem
5.1 Ensuring optimal levels of discretion
10
11
6. Conclusion
12
7. Bibliography
12
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Learning outcomes:
LO3: Discuss the reasons for agency slack, shirking, and slippage.
LO4: Outline solutions to principal–agent problems in public policy.
1. Introduction
There are many delegation relationships that you will be familiar with. At an individual level,
most people delegate the education of their children to teachers at their child’s school.
Organisations choose individuals to represent their interests, such as boards of trustees
or lobbyists who represent their interests in parliament. States also delegate some
responsibility to international organisations, such as the International Criminal Court (ICC)
or the World Trade Organization (WTO). In recent years, however, there have been
protests levelled at international organisations. Many citizens are concerned that these
organisations are not acting in their interest or are pursuing a mandate that does not
represent the best interests of all member countries. Others are convinced that global
solutions require even greater levels of delegation to these international organisations.
You may have experienced similar concerns when you engaged with individuals or groups
that act on your behalf. You might have felt, for example, that your local representative was
more interested in gaining a seat in parliament than improving infrastructure, or that your
doctor was not putting enough effort into finding a diagnosis. In these notes, you will learn
about delegation through principal–agent theory, and the advantages and disadvantages
of principal–agent relationships. You will also learn about possible solutions to the
principal–agent problem.
2. What is delegation?
Delegation is when one party (the principal) gives authority to another party (the agent) to
act on their behalf (Hawkins et al., 2006). Through the process of delegation, what is known
as a principal–agent relationship is created. Delegation is common in social, political, and
economic interactions. It is present in individual relationships and at an organisational,
national, and international level. In this unit, you will focus on principal–agent relationships
between individuals or small groups, and in the next unit you will look more closely at the
principal–agent relationships that define institutions, such as central banks or courts.
Consider the relationships illustrated in Figure 1.
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Figure 1: Examples of principal–agent relationships.
When you invest money through a stockbroker, you give the broker the authority to make
financial decisions on your behalf. When you elect a new president, you give the president
the authority to make policy decisions on your behalf. In all these instances, you are the
principal in the situation. Conversely, when you join the parent–teacher association at your
child’s school, you are an agent who has been given decision-making authority by other
parents. If you join a think tank, you are tasked with carrying out research on behalf of a
principal.
According to Hawkins et al. (2006), two factors should be present for an exchange to be
considered a principal–agent relationship:
1. A contract: The parties must have a contract in place that defines the relationship.
An agent may, for example, be required to work on behalf of the principal in a loyal
way and notify the principal of any important information. The principal’s main
requirement, on the other hand, is generally to compensate the agent for their
effort. This could be defined both by a formal or an informal agreement.
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2. Authority: The principal must have the power to create, enforce, and dissolve the
relationship.
Unlike in neoclassical economics, this contract is not assumed to be complete. Rather, the
principal accounts for imperfect contracts during the design of the relationship and puts
mechanisms in place to control the agent. Principal–agent relationships always include
discretion. The agent has the freedom to choose between several courses of action when
deciding how best to execute the goals of the relationship. These possibilities are limited
by the contract and the other controls put in place by the principal.
It is important to be able to differentiate between principals and agents in different
scenarios. To test your understanding of principal–agent relationships, engage with five
examples that ask you to identify who holds which role in the relationship.
Flip card set 1: Identify principal–agent relationships. (Access this set of notes on the Online
Campus to engage with this flip card.)
Pause and reflect:
Can you identify any other examples of principal–agent relationships in your context?
What benefits do you think each party gains from this relationship? What are some of
the negative consequences of a principal–agent relationship?
In the next section, you will learn more about why principals might decide to delegate
authority to an agent, before reviewing a detailed analysis of the costs that may result from
these relationships.
3. Gains from delegation
There are many reasons why principal–agent relationships exist, the primary one being
specialisation. These relationships often occur when it is more efficient for the agent to
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complete a task than the principal. These tasks might require resources that the principal
does not have, such as a specific skill set or knowledge of particular processes and tasks.
For example, when a policymaker gathers a group of scientists, biologists, sociologists,
and economists to create an environmental think tank, the policymaker benefits from
specialisation. It would take the principal a great deal of time to research all of these
disciplines herself, so she is willing to give the academics some discretion in order to create
well-rounded policies. States may choose to delegate to international organisations for the
same reason. Countries that are part of the ICC, for example, benefit from the specialist
human rights lawyers employed by the organisation. Delegation based on specialisation
usually only occurs when tasks need to be repeated frequently, because the costs of
delegating authority to an agent for one task are too high to merit this decision.
There are also several other reasons why delegation might occur. For example, two
individuals might delegate legal authority to a court, because they both feel that the court
will provide a fair and unbiased ruling in their case. Delegation may also occur for several
reasons at both a national and international level. Member states delegate some authority
to institutions, such as the UN. This can be done for several reasons, one of which is to
reduce the transaction costs of regional policymaking. You will learn more about principal–
agent relationships in national and international institutions in Unit 3.
While there are many benefits of delegation, there are also several reasons why principal–
agent relationships may be problematic. The Brexit decision, which refers to Britain leaving
the EU, brought European politics to the fore of international discussion. The EU functions
through a number of supranational institutions, such as the European Court of Justice
(ECJ), the European Parliament, and the European Commission. Citizens of member
states of the EU have raised concerns about the democratic deficit of these institutions
(Pollack, 2003). Accusations that bureaucrats and judges are self-serving have highlighted
popular concerns about the principal–agent relationship between citizens and the leaders
of the EU. You will learn more about issues resulting from delegation – such as moral
hazard, shirking, and slippage – in the next section.
4. Issues resulting from delegation
The concerns of EU citizens are examples of the principal–agent problem. This problem
results from information asymmetries and differences in interests between the principal
and the agent. In order to account for these factors, principals incur costs of monitoring
and enforcing the contract with the agent. All principal–agent relationships incur some of
these costs, no matter how closely aligned the interests of the principal and the agent are.
It is impossible for the principal to ascertain whether the agent is always acting in the
principal’s best interests, as it is impossible for the principal to monitor what the agent is
doing at every moment of the day. Even if this were feasible, the resources needed to
monitor the agent so closely would reduce the benefits the principal gets from delegating.
4.1 Agency slack
When studying the principal–agent problem in more detail, it is evident that there are
several issues that may result from principal–agent relationships. Agency slack occurs
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when the agent’s actions are not aligned with the interest of the principal. There are two
kinds of slack (Hawkins et al., 2006):
1. Shirking: This is when the agent does not put enough effort into meeting the
stipulated requirements of the principal. You may have experienced some
frustration with shirking in your own life. You may, for example, feel that the person
handling your retirement savings is not putting enough time and effort into making
the best possible choices for your needs. When renovating your house, you may
become frustrated when you find the builders working slower than you expected.
In both these instances, the principal benefits when the agent works at their
maximum capacity, but there are also incentives for the agent to be lazy when the
principal cannot monitor their outcomes effectively.
2. Slippage: This occurs when the agent focuses on their own priorities, rather than
on the principal’s priorities. Consider the structure of many large corporations. In
these firms, the executive team reports to the board, which is the principal in this
relationship. The board members are tasked with ensuring that the company runs
effectively and that the shareholders’ dividends are maximised. The executive
team is tasked with supporting this goal by managing the day-to-day operations of
the business.
However, sometimes executives might be incentivised to focus on their own
priorities, rather than those of the shareholders. The head of human resources, for
example, might be more concerned with protecting staff health and safety, or
securing funds for employee bonuses, than ensuring that shareholders get more
return on their investment. The CEO, on the other hand, might be more concerned
with securing a larger bonus than on ensuring the long-term sustainability of the
business. The board therefore finds that different members of the executive team
are pursuing their own priorities rather than the mandate given to them.
Extend your understanding:
It is often very difficult for the principal to create a contract that removes any possibility
of shirking or slippage. This may be due to one of several factors for incomplete
contracts that you covered in Module 1. Consider, for example, the principal–agent
relationship between Antonia and the immigration lawyer, Daan, she hired to manage
her transfer to a new office in Sydney. She feels that the reason her application has
been substantially delayed is that her agent has been slacking. Despite the lengthy
contract Antonia designer at the beginning of their relationship, she is having difficulty
enforcing the contract for the following reasons:
•
Observability: The timeline for emigration to Australia varies greatly depending on
various circumstances, and Antonia has no way to determine whether Daan is
completing his job effectively. The delays in the process could be due to genuine
delays in the Australian public service, or they could be because the lawyer is not
taking his responsibilities seriously.
•
Time and uncertainty: When Antonia and Daan met to discuss their contract,
Antonia did not anticipate that her immigration process would be more complicated
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than normal. Their contract therefore does not cover all facets of the non-standard
process that Daan has had to implement.
•
Absence of a judiciary: Although Antonia is unhappy with Daan’s behaviour, there
is no immigration court that will hear her case. Even if there were a court in place,
Antonia is unsure of her legal rights in this case. She does not want to hire another
lawyer to monitor the actions of the first lawyer.
Antonia experiences information asymmetries in her relationship with Daan. She needs
her agent to prioritise her needs, but he has many priorities that he would rather work
on. If she knew exactly how the agent’s efforts linked to results, she would be able to
create and enforce a complete contract, but the uncertainty of the emigration process
makes it difficult for Antonia to directly link Daan’s actions to specific outcomes.
This is therefore an instance of incomplete contracts and information asymmetries
reducing the efficiency of the market and creating a market failure. How do you think
Antonia should proceed with this principal–agent relationship?
Antonia’s case highlights the difficulty of monitoring an agent. Principals delegate to agents
in part because agents have specialised knowledge. However, this specialist knowledge
makes the contract hard to monitor and makes it difficult to determine if the agent is
shirking. Think about the difference between hiring a contractor to paint your house and
hiring an accountant to audit your finances. It is easier to determine if the painter is not
doing their job, as you can see the quality of their work and may notice them
procrastinating. But if you hire an accountant to complete work that you are unable to do
yourself, it is far more difficult to monitor if they are doing what you asked them to do.
One solution to this is to set up a series of metrics that the agent needs to meet. You could
require the accountant to submit regular, non-technical reports, for example. However, the
problem is that if the agent has specialised knowledge, you need to give them enough
discretion to be able to use their skills to complete the job. If you micromanage them, they
are likely to be inefficient, and you will not benefit from their specialisation. You will learn
more about this in Section 5.
4.2 Moral hazard
Another issue that may result from delegation is moral hazard. A moral hazard can occur
in principal–agent relationships where the principal bears the full costs of the actions taken
by the agent, and the agent does not bear any. As the agent is not personally
disadvantaged by the negative consequences of their actions, they may be more likely to
make risky decisions.
Consider the behaviour that contributed to the 2008 financial crisis. In the aftermath of the
crisis, it was discovered that bankers were making extremely risky financial decisions in
order to make massive profits. They exploited financial loopholes and ineffective
regulations, traded risky subprime mortgages, and earned massive bonuses for client
earnings (Dowd, 2008). But while these decisions made the banks large profits in the
short-run, they inflated the value of these assets well above what they were actually worth,
creating a market bubble. When the market bubble burst, several institutions had
insufficient capital to cover these losses and either needed to be bailed out by the
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government or go bankrupt. Because this threatened several of the country’s largest
banks, a bailout was necessary to avoid a general economic collapse. These banks had
become too big to allow to fail, meaning that the government had to bail them out because
their failure posed too great a threat to the rest of the economy. The banks did not have to
suffer the consequences of their actions but someone else did, which is the essence of
moral hazard. A congressman summed up this concern in a hearing with the head of
Lehman Brothers:
You made all this money by taking risks with other people’s money. The
system worked for you, but it didn’t seem to work for the rest of the country
and the taxpayers, who now have to pay $700 billion to bail out our
economy.
(Dowd, 2008:11)
When the behaviour of individuals in the financial sector finally came to light after the 2008
crisis, there was a public outcry. Citizens felt that their agents had used their positions to
their own gain, while many members of the public suffered huge financial losses. Since
then, new legislation has been put in place in order to improve the resilience of the banking
sector and protect public interests. Several hundred new regulations were introduced in
the swaps market alone, through the Dodd–Frank Wall Street Reform and Consumer
Protection Act. This rapid change to the contractual obligations of bankers was used to
solve the moral hazard that manifested when bankers were given too much discretion. You
will learn more about possible solutions to slippage, shirking, and moral hazard in the next
section.
4.3 Adverse selection
Antonia’s case, presented in the case study previously, is also an example of adverse
selection, which is when the principal is at a disadvantage to the agent. In Antonia’s case,
Daan has more information about a situation than she does and is able to use this power
to his own benefit. This is therefore an example of an information asymmetry, which is a
concept you were introduced to in Module 1 Unit 2. Adverse selection and moral hazard
are closely related, as they both involve information asymmetries. The most important
difference is that adverse selection is focused on asymmetries before a transaction
occurs, while moral hazard occurs after the creation of the contract.
Pause and reflect:
Practise using the skills you gained in the game theory module to the theory in this unit.
Consider what you learnt about strategic interactions in Module 2 Unit 2. How can game
theory logic be applied to the issue of delegation?
Consider a game in which Antonia and Daan are the two players. Antonia has two
options: She can either regulate and monitor the agent, or she can give Daan high
levels of discretion. Daan also has two options: He can either act entirely in the interest
of the principal, or engage in opportunistic behaviour. How would the agent’s payoffs
for opportunism change if the principal introduced financial incentives for good
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performance? How might the payoffs change if Daan is granted higher levels of
discretion?
5. Solutions to the principal–agent problem
In addressing the principal–agent problem, it is important to ensure that the agent has
optimal levels of discretion. They should be able to complete their job effectively but should
also be prevented from engaging in opportunistic behaviour. When designing a contract,
however, it is not always simple to establish how much discretion and autonomy is optimal.
Extend your understanding:
The minister of health in Easteros is concerned by the outbreaks of disease in
neighbouring regions. Easteros did not have the emergency plans in place to provide
assistance when a recent outbreak of Ebola resulted in the loss of hundreds of lives.
The minister needs to put together a committee tasked with developing large-scale
responses to medical emergencies. He envisions a multidisciplinary team comprising
public policymakers, health professionals, and specialists in international diplomacy.
The minister is a seasoned politician and is aware of the need to design an effective
contract for the committee. After some thought he puts together two strategies:
1. Strategy 1: The committee is given a broad mandate to prepare for and facilitate
emergency medical responses. They provide regular progress reports to the
minister, and quarterly results to congress. The budget for the team is allocated
based on the decisions of senior team leaders and is audited biannually.
2. Strategy 2: The committee is given the mandate to facilitate emergency medical
responses. The team establishes extensive operating procedures, which outline its
response to all possible medical emergencies. The committee is structured
hierarchically, and the work of each specialist is carefully monitored by an oversight
committee. The budget is frequently audited, and individual employees must make
applications for any unexpected costs.
Which of the strategies do you think the minister should choose? What do you think
would be the advantages and disadvantages of this strategy?
Suppose, for example, that the minister chooses Strategy 1. The committee would benefit
from a flexible contract, allowing it to react rapidly to medical disasters. However, the
minister will find it difficult to establish whether the members of the committee are shirking
their duties or engaging in corrupt practices. If, for example, the minister chooses Strategy
2, there are a variety of checks and balances in place to monitor the behaviour of the
agents and to ensure that the committee acts in the best interests of the public. The major
issue with this solution is that the team will not be able to react rapidly to a crisis due to the
plethora of rules and procedures governing its decisions. The team will be micromanaged
and encumbered by extensive rules and guidelines, and it will be unable to react to any
unpredictable outcomes with the speed required from a medical response team.
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5.1 Ensuring optimal levels of discretion
The case study in the previous section demonstrates the difficulty of establishing contracts
that grant agents optimal levels of discretion. Too much discretion results in a higher risk
of shirking and slippage, but too little can result in micromanagement, which reduces the
ability of the team to achieve its goals. There are benefits and costs to any level of
discretion that an agent is given, which can be addressed to some extent by the way
contracts and incentives are designed.
As you learnt in Module 2 Unit 1, neoclassical economics holds an assumption of
rationality. Principal–agent theory does not make this assumption, but rather focuses on
how principals manage the behaviour of agents. This means that the theories of rationality
and bounded rationality both provide interesting insights into the design of contracts.
Rational theory focuses on how agents act to maximise their utility, and how contracts
should be designed to take this into account.
Researchers of bounded rationality, on the other hand, also recognise how other
motivators for human behaviour, such as altruism, might be used to influence the behaviour
of agents (Hawkins et al., 2006). There are several ways in which the actions of an agent
can be controlled in order to ensure that the agent acts in the interests of the principal.
These include the following:
•
Monitoring: Most contracts have monitoring and reporting requirements, which
require the agent to provide information about their actions. Monitoring can either
take the form of “police patrols” or “fire alarms”. In police patrols, the principals
monitor the behaviour of agents directly, while in fire alarms, other parties are
encouraged to lodge complaints against agents who are acting improperly. Many
private and public organisations encourage whistle-blowers to come forward if they
encounter corruption or other unethical behaviour, or to provide feedback on their
interaction with an agent who has engaged in this behaviour.
•
Screening and selection: Principals are often able to choose the agents they
believe will best represent their interests. This is intended to reduce slippage by
ensuring that both parties’ interests are aligned from the beginning.
•
Checks and balances: These mechanisms are used to ensure that the agents are
adhering to their mandate. Checks and balances are generally included in the
design of an institution. An example of an institutional check is when principals hire
multiple agents with similar mandates. This reduces the information asymmetries
in the relationship and helps the principal gauge whether outcomes are being met.
•
Sanctions: Rewards and punishments can be introduced to incentivise behaviour.
Bonuses are an example of a reward for positive behaviour. Negative behaviour
could be punished by removing financial backing or resources, or by terminating
the project.
•
Socialisation: It is possible that the principal may be able to build loyalty in the
relationship with an agent over time, if the principal is seen in a positive light
(Hirschman, 1972). Many people are more willing to work hard for a boss who they
believe is fair, than for one who they believe is a tyrant.
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(Hawkins et al., 2006)
All of these strategies are founded on the assumption that agents have divergent priorities
that will cause them to act opportunistically. In some cases, however, agents may be
motivated by other factors, such as public service. Researchers have found that agents
motivated by public service are less likely to shirk or engage in other opportunistic
behaviour (Finan, Olken & Pande, 2015:17).
6. Conclusion
Principal–agent relationships are common in society at individual, organisational, national,
and international levels. Delegation is beneficial to the principal, because the relationship
takes advantage of specialisation and the division of labour. Principals may also benefit
from other factors, such as access to dispute resolution mechanisms.
However, the principal–agent relationship can be challenged by information asymmetries
inherent in the relationship. Shirking and slippage may result from this asymmetry. In order
to address these issues, principals need to design contracts that give agents the optimal
amount of discretion to allow them to complete their tasks without being unnecessarily
micromanaged. Mechanisms to reduce the principal–agent problem include monitoring
and enforcement, the selection of suitable candidates, institutional checks and balances,
and sanctions.
Engage with the small group discussion in this unit to explore real-world principal–agent
relationships.
7. Bibliography
Dowd, K. 2008. Moral hazard and the financial crisis. Available:
https://www.nottingham.ac.uk/business/businesscentres/gcbfi/documents/crisreports/cris-paper-2008-6.pdf.
Finan, F., Olken, B.A. & Pande, R. 2015. The personnel economics of the state. NBER
Working Paper, No. 21825.
Hawkins, D., Lake, D.A., Nielson, D.L. & Tierney, M.J. 2006. Delegation under anarchy:
states, international organizations, and principal-agent theory. In Delegation and
agency in international organizations. D. Hawkins, D. Lake, D. Nielson & M.
Tierney, Eds. Cambridge: Cambridge University Press: 3-38. DOI:
10.1017/CBO9780511491368.002.
Hirschman, A.O. 1972. Exit, voice, and loyalty. Boston: Harvard University Press.
Pollack, M. 2003. The engines of European integration: delegation, agency, and agenda
setting in the European Union. Oxford: Oxford University Press. DOI:
10.1093/0199251177.001.0001.
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Guidelines
1.
There are 3 questions in this assignment, You must answer.
2.
Make sure that you have carefully read and fully understood the questions before answering them.
Answer the questions fully but concisely and as directly as possible. Follow all specific instructions
for individual questions (e.g. “list”, “in point form”).
3.
Answer all questions in your own words. Do not copy any text from the notes, readings, or other
sources. The assignment must be your own work only and should be clear and explained.
Having explored the content covered in the module, you should now be more familiar with
On unite 12, we covered many concepts such as delegation relationships and the opportunities and
costs of these relationships, also about the institutional design strategies used to address the
principal–agent problem. Apply these concepts, as well as your own insights, to the questions in this
assessment.
Question 1
Talia owns the largest producer of ice cream in Easteros. She currently relies on several small
manufacturers to produce the packaging for her products. She has contracts with each of her
manufacturers and has quarterly meetings with them to discuss business for the next quarter. Other
than this interaction, she has little oversight over their work.
Over the last year, Talia’s business has boomed, and she is wondering whether she should begin
packaging her product in-house. Write a brief recommendation to Talia, highlighting the costs and
benefits of vertical versus horizontal integration. excluding in-text citations and your list of
references may not exceed 350 words.
Start writing here:
Question 2
Many countries have foreign aid programmes that provide financial or other resource assistance during
humanitarian crises. The Parliament of Easteros has voted that an annual sum of £30 million should
be allocated to global humanitarian crisis responses. The humanitarian crisis in the Democratic
Republic of Congo (DRC) will be the focus of donations for the next three years.
To familiarise yourself with global humanitarian aid, use the following resources:
The Global Humanitarian Assistance Report: Explore the GHA report, which provides an overview
of humanitarian assistance in 2018. Pay particular attention to the executive summary and
“Chapter 4: Effectiveness, efficiency and quality”.
Humanitarian crisis in the DRC: Read this brief article for context on the current humanitarian
situation in the DRC.
Imagine that you are the minister of international development of Easteros. After the vote in
Parliament, you were allocated the £30 million per year to spend on assisting vulnerable groups in the
DRC for a three-year period. You have identified three possible strategies:
1. You can set up a new governmental agency focused on humanitarian crises. The mandate of
the agency is to use the annual £30 million to identify and work directly with vulnerable groups
in the DRC. Where it is impossible to intervene directly, the agency is tasked with identifying
partner organisations in the region and then monitoring and enforcing the responsible use of
Easteros’ humanitarian assistance.
2. You can pledge £30 million to one of the specialist UN agencies, such as the United Nations
Development Programme (UNDP), the World Food Programme, or the United Nations
International Children’s Emergency Fund (UNICEF). Easteros will be contractually obligated
to provide £30 million annually for the next three years. The assistance that you provide will
be used according to the mandate of the agency that you choose, and you will not be able to
directly influence or monitor this spending.
3. You can give the £30 million directly to the government of the DRC each year. You may be
able to influence the government to use the financing for certain priorities, but it will be difficult
to enforce this agreement at a later stage. You will rely on government officials in the DRC and
other third parties, such as journalists, to provide you with informat
