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Principal-Agent Problem in Labor Economics Essay


The principal-agent model shows compensation that an agent should receive from the principal for the work done. The agent aims at making as much money as possible, while the principal would like to pay the agent as little money as possible. An agent chooses an option that maximizes the payoff. The main aim of this paper is to analyze the principal-agent model that is applied to different organizations.

Principal-Agent Model Application

The principal-agent model applies to me because incase I go to a hospital; the doctor will treat me and therefore create an agency relationship. Either the principal or the agent may hold more information than the other party, thereby making the problem of information asymmetry. In this case, the doctor serves as an agent, and I serve as the principal. The doctor may decide to give me more than the required services in order for me to pay more money. I will try to maximize the utility of the services offered by the doctor, and the doctor will maximize the profit by charging me high charges. When an employer employs me, the firm will try to pay me as little as it can, and at the same time, I will try to ask for as much payment as possible. In this case, the principal-agent model applies to me when I am trying to maximize the utility of services offered by my agent in the hospital case.

In the case of my organization, company, and business function, employees are the agents, and the business is the principle. In a company, the management is the agent, and the shareholders are the principals. Business organizations employ workers to carry out their operations that bring in revenues. For them to maximize their profits, they are being forced to use several tactics, one of them being giving employees attractive pay packages for them to be motivated in order to produce a high output. My business organization pays me wages according to the revenue at hand, given that high income attracts high wage payments and low revenues attract low wage payments. In this case, my organization will hold as much information as possible to the employers since my company wants to pay small wages to the employees while retaining huge profits. On the other hand, employees will try as much as possible to get high salaries despite their production. An employee will also receive utility from the number of units he/she delivers at the end of the day, which is the effort cost per unit. The model explains that it is not all time that an employee is motivated by the number of incentives offered by the employer.

Effects of Change on Management

Identity is useful since it suggests a natural way of behavior-changing within a population. Identity corresponds to people’s own- self-classification and classification by others. Change of management in an organization leads to a change in the identity of the organization, which means that the outside and the inside community identifies the company with the government, and growth of the management means that the organization’s identity has changed (Akerlof & Kranton, p. 10). A change in the control can make employees assume various identities according to the type of management. A worker who takes on the identity of the organization he/she works for is called an insider. Insiders act in the interest of the organization, and they lose some of their utility once they deviate from being insiders. When an employee does not identify him/herself with the organization that s/he works for, s/he are called an outsider. The employee puts little effort into his work, and s/he loses some identity once the employee deviates. When agents perceive themselves as insiders, they maximize their identity utility by exerting more effort, and they do not require large monetary rewards to induce them to work hard (Ichniowski and Shaw 92). On the other hand, when employees perceive themselves as outsiders, they require a higher wage differential wage as their compensation for working in the firm’s interest.

Salaries and Benefits Increase

Salaries and benefits increase faster in the labor market than inside a particular company due to various reasons. Wages and advantages of the labor market may increase based on the kind of agents that firms have. If companies employ outsider employees, salaries and services will increase in order to motivate them to work, but in a company with insider employees, salaries will not increase since they are not motivated by the wages. Another reason for the increase in prices in the labor market is due to the type of employees that firms need to employ (Gary & Kuhn 172). If organizations want the best employees, they always offer higher salaries to them hence increasing the wages in the labor market. Lastly, when the revenue earned by companies increases, the salaries and benefits of the employees also increases, thereby increasing the salaries and services in the labor market.


In Conclusion, as discussed above, the principle-agent model helps the management to understand reasons for the shift in salaries and benefits in the labor market, the behavior of employees under the principal and agent perspective, the identity of employees, and incentives for employees. Managers need to understand this model and use it effectively in a company’s management.

Works Cited

Akerlof, George, and Rachel, Kranton. “Identity and the Economics of Organizations.” The Journal of Economic Perspective 19.1 (2005): 9-32

Gary, Changes, and Peter, Kuhn. “Lab Labor: What Can Labor Economists Learn from the Lab?” NBER Working Paper No. 15913. (, 2010).

Ichniowski, Casey, and Shaw, Kathryn. “Insider Econometrics: Empirical Studies of How Management Matters.” NBER Working Paper No. 15618, (2009).

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1. IvyPanda. "Principal-Agent Problem in Labor Economics." February 12, 2021. https://ivypanda.com/essays/principal-agent-problem-in-labor-economics/.


IvyPanda. "Principal-Agent Problem in Labor Economics." February 12, 2021. https://ivypanda.com/essays/principal-agent-problem-in-labor-economics/.


IvyPanda. 2021. "Principal-Agent Problem in Labor Economics." February 12, 2021. https://ivypanda.com/essays/principal-agent-problem-in-labor-economics/.


IvyPanda. (2021) 'Principal-Agent Problem in Labor Economics'. 12 February.

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