Introduction
Labor economics is an integral part of economics because it explains how the labor market functions and operates and its dynamics. The labor market is the market where workers and employees interact. This means that there are suppliers of labor and the people who need that labor.
The suppliers in this case are the workers or employees and the people who demand the labor are the employers. Smith states that the principal agent relationship always occurs in the labor market where the principals entrust the agents with their businesses. (Smith, 2003 89) The principal in this case is the owner of the business and the agent is the manager who will manage the business on behalf of the owner
Principal agent relationship
The principal agent relationship can be defined as an arrangement or a contract between one person called a principal and the other called an agent to carry out some work. Currie and Wolpin state that a principal can be anyone who is legally able to carry out an act. Legally able means that they are mentally stable and they are not minors.
An agent can be anyone who is qualified enough to comprehend the act that is being done by the principal. (Currie & Wolpin, 2001 54) The principal agent relationship is also called the agency relationship. A contract that is signed by an agent on behalf of the principal is the contract of the principal and therefore the principal has the right to exercise any term that are in the contract for example the principal can give anyone authority to perform specific or general duties.
The agency relationship can be either formal where there has to be a valid contract or some writing or informal where there is no valid contract or any kind of writing that is authorizing the agent to act on behalf of the principal. The agency relationship must also be legal. This means that the agent and principal should engage in legal activities
It is evident that in the principal agent relationship, the agent is acting on behalf of the principal. The agent therefore has to act under the authority of the principal. This relationship is based upon trust and loyalty from both sides but especially from the agent. The agent has to convince the principal that he will follow his instructions to the latter and that he will not be negligent when carrying out any of the works entrusted to him by the principal.
Hirshleifer et al postulate that the relationship is also based on the assumption that the agent is to act ethically and therefore he will not take advantage of the task at hand for his personal gains or satisfaction. (Hirshleifer et al, 2005 169)The principal in turn should exude a lot of confidence in his agent and also act ethically. These bases will ensure that there is a strong bond, trust and understanding between the two parties and hence a fruitful relationship.
The agent has an obligation to be truthful to the principal all the time and disclose all the necessary and important information that affect the business or the task at hand or any other factors that affect the agency relationship. The agent should also refrain from any activities that may harm the agency relationship
The principal agent problem
The principal agent problem always arises where there is misleading information or information that is not symmetrical or complete when a principal hires an agent.
Both the principal and the agent will try to satisfy their needs and sometimes they can do that at the expense of one another and therefore a problem arises. Information that is not symmetrical is caused when the two parties both have different economic information that is used in economic decisions. The differences in economic information affect a lot of decisions that are made daily.
The moral hazard problem is one of the causes of a principal agent problem. It occurs when one party gives misleading information to the other so that they can satisfy themselves. Jollands et al postulate that the moral hazard problem is related to adverse selection and information not being symmetrical. In all these cases, one party in the relationship always has access to more information than the other and he uses this information badly to benefit himself. (Jollands et al, 2007 78)
The party is always insured from risk and therefore he can act unethically for example if the agent is insured, he has financial security and therefore he can engage in risky contracts that may be harmful to the business or to the task at hand. The principal agent relationship can arise among various parties for instance the manager and the shareholders. Shareholders entrust the managers to act on their behalf and manage for them their businesses.
A problem will occur when the managers act unethically to satisfy their personal needs at the expense of the business or the shareholders’ wealth. Another principal agent relationship is between the insurer and the insured. An agent principal problem will arise when the insurer incase of a loss gives false information regarding the hazard that occurred so as to gain falsely.
It may also arise when the insured does not take all the facts into account regarding a loss and therefore gives less compensation to the insurer. The principal agent problem can also be looked at in a different dimension. Surhone, Timpledon and Marseken state that in economics, the principal agent relationship occurs when one party who is the principal, motivates the other party who is the agent to act on his behalf. (Surhone, Timpledon & Marseken 2009, 54)
The problem mostly arises when one party gains at the expense of another for example when the principal motivates or compensates the agent when he carries out certain activities that benefit the principal but are costly to him. Such problems occur when the contract between the principal and the agent was signed under inaccurate or incomplete information and therefore renders it vague or when the contract was signed under a lot of uncertainties and risks.
Geetika et al state that in these cases, there is little information regarding the contract and the duties that are supposed to be performed or even the goals that are supposed to be satisfied and therefore they have to provide the agents with incentives and compensation packages to motivate them so that they can act ethically and in a way that the principals would like them to act so as to accomplish the tasks at hand and to enable the principals to gain. (Geetika et al, 2005 302)
The principal therefore has to apply different methods in trying to motivate the agents but also benefiting their personal needs and accomplishing their goals and objectives for example the principal can change the way the task is carried out or the way to run the business so that even if the agents act in a way that they satisfy their personal goals, then the goals of the principal are also satisfied or if they make decisions or choices that benefit their self interests, these decisions and choices will also be the same as the decisions that the principal would have made or the choices that the principal would have taken
Ways of motivating the agent to act ethically
To get rid of the agency problem, the principal must motivate or compensate the agents so that they can act in a way that the principal would wish them to act.
Principals can use the employment contracts to motivate or compensate the agents. According to Bolton and Dewatripont, the contracts include the ways in which the work is to be performed, the levels of performance required, the measure of that performance and the appraisal and compensation process. (Bolton & Dewatripont, 2005 135) Contracts vary in nature because of the difference in the type of work being done and the difference in the nature of the relationship
Principals can also use non financial compensation packages to compensate their agents. This involves motivation using other methods that do not involve money. This may include appraisal and recognition or provision of higher authority or the permission to engage in activities that may benefit the agent at a personal level.
Every employer takes pride in their work and this is no exception for the agents. Smart states that introduction of performance related pay will therefore reduce the pride of the agent because it will be based more on economic terms between the agent and the principal and the principal will not appreciate the work of the agent. (Smart, 2010 208)The principal should therefore avoid such methods of remuneration
The principal can also motivate the agent by improving the working conditions under which the agent is working. The principal should not put so many strict rules and he should allow the agent to be flexible when carrying out his duties and when making decisions that affect the business.
Ways of solving the principal agent problem
The principal can however undertake certain actions to try and solve the problems that arise from the principal agent relationship. First, the principal can give threats of firing the agent incase of any unethical actions by the agent or incase of any losses by the principal arising form the actions of the agent. McConnell, Brue and Macpherson state that these threats will enable the agent act ethically and in a manner that the principal may want them to act so as to avoid being fired and losing their jobs. (McConnell, Brue & Macpherson, 2003 218)
Secondly, the principal can take over the work that is being done by the agent, the business or the company and do it alone or give it to another person to do it.
This will leave the agent jobless. Lane and Ersson postulate that threats of take over will ensure that the agent acts ethically or appropriately and provides all the information needed by the principals so that they can benefit the principals and ensure that they achieve their goals in due time. (Lane & Ersson, 2000 174)
The agent will try as much as possible to satisfy the needs of the principal so that they do no not lose their jobs when the principal takes over the business. Another way of solving the principal agent problem is by rewarding the agent.
When an agent acts ethically and satisfies the needs and goals of the principal, the principal should reward him so that he can feel motivated and act in the same way always. When the agent is motivated they will always act rationally and ethically and will always aim at ensuring that the principals benefit from their actions
Conclusion
The principal agent relationship is very common and it has proven to work where there is trust and commitment between the two parties. Loyalty is also important in such a relationship and the terms of the contract should be well defined and stated to avoid any misunderstandings
References
Bolton, P & Dewatripont, M. (2005) Contract theory. Massachusetts: MIT Press. Pp. 724
Currie, M. J & Wolpin, I. K. (2001) Labor economics. New York: Routledge. Pp. 165
Geetika et al. (2008) Managerial economics. London: McGraw-Hill publishers. Pp. 538
Hirshleifer, J et al. (2005) Price theory and applications: decisions, markets, and information. Cambridge: Cambridge University Press. Pp. 614
Jollands, N et al. (2007) Mind the gap: quantifying principal-agent problems in energy efficiency. New York: OECD Publishing. Pp. 219
Lane, E. J & Ersson, O. S. (2000) the new institutional politics: performance and outcomes. New York: Routledge. Pp. 329
McConnell, R. C. Brue, L. S & Macpherson, A.D. (2003) Contemporary labor economics. London: McGraw-Hill. Ed 6. Pp. 654
Smart, C.J. (2010) Higher Education: Handbook of Theory and Research. Canada: Springer. Pp. 569
Smith, W. S. (2003) Labor economics. New York: Routledge. Ed 2. pp. 448
Surhone, M. L. Timpledon, T. M & Marseken, F. S (2009) Principal-agent Problem: Information Asymmetry, Profit Sharing, Performance Measurement, Efficiency Wages, Dual Labor Market, Time and Motion Study, Off-balance-sheet, Contract Theory, Agency. London: Betascript publishers. Pp. 128