The principal-agent problem is a situation where an agent is expected to act in the best interest of a principal. But, the agent has different incentives to the principal, leading to a conflict of interests.
A principal delegates an action to another individual (agent), but there are two issues. Firstly, the principal does not have full information about how the agent will behave. Secondly, the interests of the principal diverge from that of the agent, meaning that the outcome is less desirable than the principal expects.
For example, a shareholder (principal) wants to maximise profits for his firm. He hires a manager (agent) to run the business. However, due to agency costs, the shareholder cannot fully know how hard the agent is working and to what extent the manager is fulfilling the contract. Also, in this situation, the manager does not share the same interest in maximising profits as the owner.
The principal-agent problem can lead to market failure because the agent pursues his own self-interest rather than that of the principal and the business may be run in an inefficient way. In extreme cases, the mutually beneficial action may not happen because the principal lacks information.
The principal-agent problem can also lead to an individual taking an excessive risk because the ultimate cost is borne by someone else. This is an example of moral hazard.
For example, an investment banker may gain a bonus for making high profits. This encourages the banker to take risky investments. If he fails and loses $700m, the losses are absorbed by the bank (or taxpayer) – not by the individual banker. This has led to major banking collapses, such as rogue trader Nick Leeson and Barings Bank (1995).
Costs of Principal-Agent Problem
Agency costs. Due to information asymmetries, principals may be unaware of how much a contract has been fulfilled. Principals may be reluctant to enter into a contract at all for the fear that they will not know what is going on. For example, a landlord may be reluctant to lend if he fears that a tenant may mistreat his property and be unable to know how it is cared for. If a mutually beneficial transaction doesn’t occur at all, this would be a significant welfare loss.
“We define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximisers, there is good reason to believe that the agent will not always act in the best interests of the principal.”
Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure Jensen and Meckling (1976)
Inefficiency. Principal-agent problem enables agents to produce sub-optimal work. For example, managers may be profit-satisfiers – leading to higher costs and less profit.
Cost of monitoring/incentives. To try and overcome the principal-agent problem, the principal will have to spend money on monitoring and providing incentives for workers.
“However, it is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint.”
Jensen and Meckling (1976)
Overcoming Performance Related Pay
Tipping. Waiters who rely on tips for pay will have their interests more aligned with owners (principals). This can be an effective way to remove the principle-agent problem. However, due to social conventions, it is difficult to move away from tipping in all but the limited industries of restaurants and cafes
Performance Related Pay. A simple solution to give agents an incentive to work hard. However, it depends on how Performance Related Pay is implemented. Without sufficient flexibility, it can create tension in the workplace and reduce co-operation. Also, some jobs are suitable for objective evaluation, e.g. fruit pickers have an easily quantifiable output. But, other jobs, such as teaching and managers require more subjective evaluation.
Different workplace environment. Workers are motivated by a variety of factors other than pay. Some of the main motivations are not pay, but pride in work and a sense of achievement. A management structure which encourages independence and workers taking responsibility for work can be more effective than crude pay bonuses.
Moral Hazard
Moral Hazard is the concept that individuals have incentives to alter their behaviour when their risk or bad-decision making is borne by others.
Examples of moral hazard include:
- Comprehensive insurance policies decrease the incentive to take care of your possessions
- Governments promising to bail out loss-making banks can encourage banks to take greater risks.
Conditions necessary for moral hazard
- There is information asymmetry. Where one party holds more information than another. For example, a firm selling sub-prime loans may know that the people taking out the loan are liable to default. But, the bank purchasing the mortgage bundle has less information and assumes that the mortgage will be good.
- A contract affects the behaviour of two different agents. In some cases, two parties face different incentives. If you are insured, then you may have less incentive to take care against risks. For example, if a country knows it will receive a bailout from the IMF, then it may feel less incentive to reduce debt. Moral hazard is particularly a problem in the insurance market because when insured, people may be more liable to lose things.
Definition of Moral Hazard
“any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.” [1]
– Paul Krugman
In the great depression of the 1930s, many American banks went bankrupt. This had a devastating impact on the economy, leading to decline in money supply, fall in output and rise in unemployment. Since this financial crisis, there has been an implicit understanding the government should bail out banks and prevent them going bankrupt.
However, this implicit guarantee to bailout banks means that banks have a greater incentive to take risks.
If risks lead to higher profit – they benefit
If risks fail and lead to bankruptcy – the banks will benefit from a government bailout.
A simplistic model of the dangers of moral hazard.
The financial crisis of 2008/09 led to many banks/large financial institutions to run short of liquidity. In the UK and US, governments intervened offering large-scale bailouts.
The problem with bailing out banks is that it creates another precedent for the future. It may encourage banks to take risks in the future.
- However, despite this problem of moral hazard, the economic costs of allowing banks to fail would be even greater.
- The solution is to try to separate banks into investment and saving branches. In other words, governments will guarantee ordinary savings, but if banks make a risky sub-prime investment, there is no need for governments to bail out this branch of bank activity.
Other examples of Moral Hazard
1. Insurance and consumer behaviour
If your bike is not insured, you will take great care to avoid it getting stolen. You will lock it carefully. However, if it becomes insured for its full value then if it gets stolen you do not really lose out. Therefore, you have less incentive to protect against theft. This becomes a situation of asymmetric information. The insurance company may assume you will look after your bike, but you may know that you won’t.
In these cases, an insurance firm faces a dilemma.
- When your bike is uninsured, it has, say, a 10% chance of getting stolen. Therefore, if the bike is worth £1,000. The cost of insurance would be based around £100.
- However, once insured, the bike may now have a 30% chance of getting stolen. Therefore, if the insurance firm charges £100 based on the 10% risk, it will lose out.
- This could lead to a missing market. The insurance firm doesn’t want to insure bicycles because people change their behaviour.
2. Moral hazard and Sub-Prime Mortgages
In the case of the sub-prime mortgage market 2000-2007; lenders faced a situation of moral hazard. They were able to sell on mortgage bundles to other financial institutions. Because there was strong demand from other people, and because other banks were taking on all the risk, the mortgage companies had less incentive to check the mortgages could be repaid. Therefore, there was a big growth in sub-prime mortgage lending with inadequate checks made.
3. Fiscal and Monetary Union
It is argued that membership of the Euro can cause a type of moral hazard. A country in the Euro may assume that if it gets into difficulties, other countries will bail it out. Therefore, they may allow their debt to grow. For example, when Greece joined the Euro, it benefited from low-interest rates because it was in the Euro. This encouraged them to keep increasing public sector debt – until markets realised too late that they actually had high, unsustainable debts.
4. Management
If managers or civil servants have a guaranteed job for life, this may alter their work incentives. If they are protected from making bad decisions, they have a greater willingness to make self-serving decisions or help out friends. This is more of a problem if it is difficult to evaluate who is accountable for the decision. It is related to the principle-agent problem and can lead to outcomes such as profit satisficing.
5. Health insurance
J. Arrow (1963) in “Uncertainty and the Welfare Economics of Medical Care,” argued that medical insurance companies may be reluctant to offer full insurance because doctors have an incentive to over-prescribe treatment – even if risky and not certain to work. Doctors will take on risky treatment because the cost is borne by others (the insurance companies)
6. Moral Hazard from IMF intervention.
Free market economists have argued that IMF intervention for countries experiencing crisis, encourages risky behaviour by countries. (Criticisms of IMF)
Overcoming Moral Hazard
1. Build in incentives. To avoid moral hazard in insurance, the insurance firm will design a contract to give you an incentive to make you insure your bike. This is why they will not insure for the full amount. Usually you have to pay the first £50 of an insurance claim. Insurance firms also make the process of getting money difficult. This means that you become more reluctant to make claims and so will try to avoid having your bike stolen in the first place.
2. Penalise bad behaviour. The government could bail out banks, but penalise those responsible for making the reckless decisions. In the case of Greece, bailout funds are being given very reluctantly and with conditions to reform and pursue austerity.
3. Split up banks so they are not too big to fail. The problem occurs when banks with consumer savings also take on risky investments. It is the risky investments which need a bailout.
4. Performance related pay. To avoid moral hazard in the labour market, there can be some form of performance evaluation and no guarantee of a job for life.
Readers Question on Moral Hazard – can it be when information is complete when information is asymmetric when information is biased against the consumer or is it when information is exaggerated?
Two parties may have good information, but the presence of a contract changes peoples behaviour, e.g. in the case of insurance. In that sense, the information isn’t really complete because the insurer isn’t aware the contract will change peoples behaviour. Exaggerated or asymmetric information can all lead to moral hazard.
It is worth being aware of adverse selection. Adverse selection occurs when there may be a bad choice of products due to asymmetric information.
Macroeconomic Instability
Macroeconomic instability – When an economy enters into prolonged recession and high unemployment – or inflationary boom which is unstable
Readers Question: my question is whether economic instability means high and fluctuated inflation, employment and unsustainable growth or has other definition?
Economic instability can take various forms. In recent years, we have witnessed a few examples of this. The main types of instability are:
- Inflation – The cost-push inflation of the 1970s. In extreme cases, hyperinflation, e.g. Zimbabwe 2008
- Credit crunch – When the financial sector becomes short of liquidity causing a fall in bank lending, e.g. 2008/09
- Asset bubbles/bust – When asset prices rise rapidly due to irrational exuberance – but then fall.
- Economic growth/recession
- Balance of payments crisis – Countries reliant on a commodity like oil, can be adversely affected by fall in price – leading to capital outflows, e.g. Venezuela, Russia (2016)
- Bond crisis – Eurozone crisis of 2012 saw a rapid rise in bond yields due to high debt and a shortage of liquidity.
More detail on Types of Economic Instability
Inflation
In the 1970s, the UK (along with other Western Economies saw inflation above 20%). This was due to higher oil prices, rising wages and inflation expectations. The high inflation created uncertainty because
When prices are rising rapidly, firms and consumers become uncertain about future costs, prices and profitability – this uncertainty tends to reduce their willingness to invest. When inflation is very high and when inflation is above interest rates, the real value of money can decline quickly causing savings to fall in value. In the 1970s, many investors who bought government bonds saw the real value of their savings decline.
Further reading – costs of inflation
Hyperinflation
In extreme cases, inflation can get out of hand and make ordinary economic transactions difficult. For example, in Zimbabwe, the government responded to a declining economy by printing money, but this caused money to rapidly lose its value.
When money loses value, economies can become very unstable as consumers have to resort to a barter economy. For example, the hyperinflation of Zimbabwe created great economic misery and a collapse in living standards. At its peak, Zimbabwe had a daily inflation rate of 98% – making ordinary transactions difficult as people lost confidence in money.
Further reading – hyperinflation
Asset Bubbles
In the early 2000s, there was a global boom in housing. Countries like US, Spain and Ireland saw rising house prices – which encouraged a boom in building. However, the asset bubble proved unsustainable and when the market turned, house prices fell. A volatile housing market affects the reset of the economy. Rising asset prices (especially housing) encourage spending as people remortgage their house. But, a fall in house prices causes this wealth effect to evaporate and people become cautious over spending. The fall in house prices in US and Europe was a significant factor behind the recession of 2009.
Bond crisis
In 2011 and 2012, the Eurozone saw a shortage of liquidity in the bond market. This caused bond yields to rise as markets were less willing to buy government bonds. This led to pressure for fiscal austerity – which in turn led to lower economic growth.
Economic growth/recession
Volatile rates of economic growth have important implications on economic stability. In a recession, with falling output, there is a rise in unemployment, poverty, fall in confidence and a rise in government borrowing. Recessions can cause firms to go out of business so they become more risk averse about investing.
Central banks endeavour to keep economic growth stable and avoid ‘boom and bust‘ cycles – where growth is rapid causing inflation, but followed by an economic downturn.
Balance of payments crisis
A balance of payments crisis occurs when a country struggles to meet foreign repayments. For example, if export revenues fall (due to falling in oil prices), there will be a rapid deterioration the current account balance of payments. This will cause a depreciation in the exchange rate. If the depreciation is rapid, it can cause individuals to try and put their money in foreign currency to protect its value. This leads to capital flight and can put further pressure on the currency. As the currency devalues, it causes inflation and increases the cost of foreign debt repayments.
The South East Asian crisis of 1997 occurred when foreign investors lost confidence in these emerging economies and sought to withdraw funds. It led to rapid depreciation and further falls in confidence.
Further reading – Asian financial crisis of 1997
Other types of economic instability
Confidence. Economic instability is linked to confidence. When the economy shows signs of instability, consumers and firms become risk-averse. Typically, when people worry about the future, they save a higher % of their income. This higher saving rate can cause a larger fall in output and more instability. It is known as the paradox of thrift.
Labour Unrest. Large-scale strikes can cause lost output and a shortage of key public services. (e.g. The Winter of discontent in the 1970s)
Banking system. When banking system ran out of credit and there was a fall in interbank lending, many realised how reliant on the banking sector the economy was.
