Principal–agent problem

[citation needed] The way in which these mechanisms are used is different in the two parts of the economy which Doeringer and Piore called the "primary" and "secondary" sectors (see also dual labour market).

The secondary sector is characterised by short-term employment relationships, little or no prospect of internal promotion, and the determination of wages primarily by market forces.

According to "Videbeck, a researcher at the New Zealand Institute for the Study of Competition and Regulation[,] '[i]n theory, tipping can lead to an efficient match between workers' attitudes to service and the jobs they perform.

In the hopes of getting a larger tip, a server, for example, may be inclined to give a customer an extra large glass of wine or a second scoop of ice cream.

While these larger servings make the customer happy and increase the likelihood of the server getting a good tip, they cut into the profit margin of the restaurant.

On a related note, Drago and Garvey (1997) use Australian survey data to show that when agents are placed on individual pay-for-performance schemes, they are less likely to help their coworkers.

Studies suggest that profit-sharing, for example, typically raises productivity by 3–5% (Jones and Kato 1995, Knez and Simester 2001), although there are some selection issues (Prendergast).

[18] Furthermore,[19] formulated from their studies that compensation tend to have an impact on performance as a result of risk aversion and the level of work that a CEO is willing to input.

This essentially states that any measure of performance that (on the margin) reveals information about the effort level chosen by the agent should be included in the compensation contract.

Because of this, the more difficult it is to completely specify and measure the variables on which reward is to be conditioned, the less likely that performance-related pay will be used: "in essence, complex jobs will typically not be evaluated through explicit contracts."

Leventis shows that New York surgeons, penalised for exceeding a certain mortality rate, take less risky cases as they approach the threshold.

Courty and Marshke (1997) provide evidence on incentive contracts offered to agencies, which receive bonuses on reaching a quota of graduated trainees within a year.

This means that methods such as deferred compensation and structures such as tournaments are often more suitable to create the incentives for employees to contribute what they can to output over longer periods (years rather than hours).

In practice, however, the incentive mechanisms which successful firms use take account of the socio-cultural context they are embedded in (Fukuyama 1995, Granovetter 1985), in order not to destroy the social capital they might more constructively mobilise towards building an organic, social organization, with the attendant benefits from such things as "worker loyalty and pride (...) [which] can be critical to a firm's success ..." (Sappington 1991,63) Subjective performance evaluation allows the use of a subtler, more balanced assessment of employee performance, and is typically used for more complex jobs where comprehensive objective measures are difficult to specify and/or measure.

Whilst often the only feasible method, the attendant problems with subjective performance evaluation have resulted in a variety of incentive structures and supervisory schemes.

Much of the discussion here has been in terms of individual pay-for-performance contracts; but many large firms use internal labour markets (Doeringer and Piore 1971, Rosen 1982) as a solution to some of the problems outlined.

Nelson (2007) also indicated that when the larger the price (incentive) the more inclined the agent (employee in this case) is to increase their effort parameter from Neilson's studies.

Secondly, it reduces the danger of rent-seeking, because bonuses paid to favourite workers are tied to increased responsibilities in new jobs, and supervisors will suffer if they do not promote the most qualified person.

If however the risks taken are systematic and cannot be diversified e.g., exposure to general housing prices, then such failures will damage the interests of principals and even the economy as a whole (cf.

Tournaments represent one way of implementing the general principle of "deferred compensation", which is essentially an agreement between worker and firm to commit to each other.

Overall, the evidence suggests the use of deferred compensation (e.g., Freeman and Medoff 1984, and Spilerman 1986—seniority provisions are often included in pay, promotion and retention decisions, irrespective of productivity.)

In this case, there is also little incentive for the tenant to make a capital efficiency investment with a usual payback time of several years, and which in the end will revert to the landlord as property.

The energy efficiency principal agent problem applies in many cases to rented buildings and apartments, but arises in other circumstances, most often involving relatively high up-front costs for energy-efficient technology.

The issues of market barriers to energy efficiency, and the principal agent problem in particular, are receiving renewed attention because of the importance of global climate change and rising prices of the finite supply of fossil fuels.

[30] When managing personnel in an organisational setting, the principal-agent problem surfaces when employees are hired to perform specific tasks and fulfil certain roles.

In the context of public administration, bureaucrats have an information advantage over the government and ministers as the former work at the ground level and have more knowledge about the dynamic and changing situation.

Political interference happens when the politicians try and influence the decisions of public servants or bureaucrats to try and push their own interests which ultimately leads to policies being warped.

Agency theory can be subdivided in two categories: (1) In adverse selection models, the agent has private information about their type (say, their costs of exerting effort or their valuation of a good) before the contract is written.

In principal–agent models, the agent often gets a strictly positive rent (i.e. their payoff is larger than their reservation utility, which they would get if no contract were written), which means that the principal faces agency costs.

Contract-theoretic principal–agent models have been applied in various fields, including financial contracting,[39] regulation,[40] public procurement,[41] monopolistic price-discrimination,[42] job design,[43] internal labor markets,[44] team production,[45] and many others.