Principle-Agent Theory

Principle-agent theory arises in a business management context associated with behavioral studies of employer-contractor or employer-employee interactions but it can be applied to public and non-profit settings as well. Early work centered on dilemmas of dealing with incomplete information in insurance industry contracts (Spence and Zeckhauser, 1971; Ross, 1973). The theory was soon generalized to dilemmas associated with contracts in other contexts (Jenson and Meckling, 1976; Harris and Raviv, 1978). Because some research in this area utilizes experiments in small group interaction, there is a close relation to game theory, as some principal-agent writers make explicit.

o Principal-agent problem. The central dilemma investigated by principal agent theorists is how to get the employee or contractor (agent) to act in the best interests of the principal (the employer) when the employee or contractor has an informational advantage over the principal and has different interests from the principal. Sappington (1991) provides a discussion of principal-agent incentive problems.

 Privatization as a solution to the principal-agent problem. Principals must balance agency costs against costs of debt financing and other costs associated with not separating ownership (sovereignty in the public sphere) from control. The issue of privatization of government services hinges not only on the relative production costs in the public vs. private sector, but also on agency/transaction costs. Specifically, the issue hinges on finding the optimum point of privatization where the marginal total cost (agency costs plus production costs) equal their marginal benefits. This is made more complicated by the fact that there are many forms of separation of ownership/sovereignty from control, including many forms of contracting out, which can carry high agency costs. Indeed, contractors may be in-house governmental agents, not representing privatization at all. See Jensen and Meckling...