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Principal agent problem

Due to globalisation, it is essential for firms to hire appropriate workers as they can directly and indirectly effect the profitability of the firm. Thus, there are numerous settings in which the principal (employer) delegates authority to an agent (worker) to act on his behalf as this agent has a benefit in terms of expertise or information. This informational advantage can create a problem for the principal if there is a misalignment between the interests of the two parties (Principal Agent Theory, 2019). This paper will look to identify the principal-agent problem and discuss the appropriate incentives in order to solve this problem. Furthermore, by using empirical literature, discuss the extent to which these incentives are effective or not. Scientific literature states that this principal-agent relationship creates a fiduciary relationship between the parties involved which implies that the tasks appointed to the agent must be carried out with the principal’s best interest in mind. However, agents may operate in their self-interest which emerges from asymmetric information: the principal and the agent possess different information (Chen, 2018). The presence of this can lead to two issues including adverse selection and moral hazard. The former occurs when there’s a lack of symmetric information prior to a deal between two parties. In this case, one party benefits and the other is at loss due to lack of information. The latter occurs when there is a change in the behaviour of one party (agent) once the contract for the performance of some service has been agreed upon (Dawson, 2018). The agent (worker) may have an incentive to back out to maximise their utility. The cost of this opportunistic behaviour is borne by the less informed party (firm). Workers tend to shirk, which is an action of not putting in your best effort. This unobserved action can affect the profitability of the firm. Moral hazard is mostly seen in labour markets as the contracts are very incomplete (they do not state the amount of effort expected out of a worker). Even though business owners can use monitoring to mitigate the risks associated with asymmetric information through supervisors, punch-cards and video surveillance, in reality, it is very costly and might prove to be counterproductive as employees may not like not to be monitored all the time. Furthermore, the worker is more informed about his own productivity and effort which is difficult to monitor or assess. Johnson (1950), Cheung (1969), and Ross (1973) all argued in their published papers that the business owner and the worker have conflicting interests and therefore a worker’s performance or productivity is determined by the ability of the business owner to provide incentives that ensures that the workers exert maximum efforts in achieving business goals or objectives (Lazear and Moore, 1984). Being economists, a number of effective incentives can be gathered in order to align the interests of principals and agents. Given the importance of employees’ productivity and motivation to create value for the company, business owners have the profit incentive to reduce the principal-agent problem. The most common strategy for businesses to increase employee productivity is financial incentives such as increased pay, bonuses or allowance. This monetary benefit is designed to increase the agent’s motivation and therefore their productivity (2019). Thus, if the agent is aware that his pay will be closely influenced by his productivity level, he will seek to put in more effort to meet the objectives set by the principal, rather than simply work indifferently at his/her initial pace (Weitzman and Kruse, 1990). Firstly, the incentive which includes offering piece-rate pay to the agents refers to compensating the workers based on the quantity of output they have produced. Piece-rate incentive plans are designed to prompt additional employee effort, increase production and, as a result, remuneration. (Seiler 364, 1984). This system links pay to productivity. While this is a suitable approach for high ability workers, it can be highly effective if increasing the firm’s productivity is regarded as a key objective. In addition, not only do employees become more efficient, but they also work towards improving their skills, so as to maximise the output produced. This kind of pay is in a situation where the output of the individual is known. Research shows that this form of pay structure can have advantages like to overcome monitoring costs and attracting a pool of productive workforce which can positively affect and firm’s profitability. Also, worker’s cognitive abilities play a crucial role in determining their inducements in completing a given task and receiving compensation. This implies that workers can be enhanced by exploiting the short-comings of decision making. This concept of loss aversion simply means that for humans, the negative affect of a loss is more than the positive effect of a gain. For example, employees which are compensated in the form of pre-paid commissions value this pay and work harder. Eric Seiler (1984) states that in retail sectors, as low as 5 to 10% of employee’s wages are paid in commissions or bonuses while the figure increases in the manufacturing sector to about 33%. Employees working under manufacturing had a larger dispersion of earnings than employees working under retail being mostly compensated under a fixed-pay system. It was also indicated that due to added incentive of earning more income, manufacturing workers exhibited increased effort by working harder (Seiler 364, 1984). Gneezy and Rustichini (2000) conducted a study to examine the relationship between monetary compensation and worker productivity. It was indicated that monetary incentives increased worker productivity. They also discovered that small incentives had a negative impact on worker productivity when compared to no incentives (Gneezy and Rustichini 807, 2000). In the year 1994/95, management changes conducted by Satelitte Glass Corporation involved changes in remuneration structure from an hourly based pay to a piece rate framework (Lazear 1346, 2000). This transition indicated that there was a 44% increase in worker productivity with a 10% increase in pay. The increase in worker productivity was proved to not only be due to the change in pay policy but also due to the company recruiting highly skilled/ability workers. It was also of note that ambitious and driven workers performed better in a piece rate system as they could significantly differentiate themselves, work hard and earn more. There was a transition to a system which linked pay to productivity. Hourly based wages did not differentiate worker performances and hence workers were less likely to exert themselves (Lazear 1347, 2000). Another incentive is efficiency wages theory which supposes that a business can increase its revenues by increasing the wages of its workers over and above the current market rates. The theory argues that this will increase worker productivity, reduce staff turnover rates, improve employee morale and attract the high ability workforce. The existence of involuntary unemployment and wage differentials is the reason for the incentive of efficiency wage. In a conventional setting where all workers receive the market wage and there is no unemployment, if a worker chose to shirk he will be fired. Since that worker can be immediately hired somewhere else, he does not pay a penalty for his behaviour. Therefore, under full employment, workers will choose to shirk as the worst possible outcome is to get fired and get hired again. In order to induce workers to work hard, the firm attempts to pay wages above the market wage so that if a worker is caught shirking and is fired, he will pay a penalty. With unemployment, even if all firms pay the same wages, a worker has an incentive not to shirk because if he is fired, an individual will not get a job immediately. The equilibrium unemployment rate must be large that it pays workers to work rather than to take the risk of being caught shirking. This theory posits that there is a clear relationship between profits and worker compensation but this assumption has its flaws. It is fundamental argument rests on the wage differentials which do not indicate individual skills. It also gives no clear way of measuring individual productivity which is essential in ascertain the relationship. Secondly it does not take into account that firms rarely lower their wages when there is an oversupply of labour. Lastly it does not provide sufficient empirical evidence to show the correlation between wages and compensation (Raff and Summers 58, 1987). Raff and Summers (1987) examined the impact of the introduction of the five-dollar day program by Henry Ford in 1914. This was a 100% increase in workers’ wages. This action resulted in long job queues by prospective employees. It also significantly improved worker productivity resulting in increased profits. The company also witnessed a decrease in absenteeism and staff resignations. Even though Ford experienced success with five-dollar day program. It must be observed that most of the jobs available were low skilled jobs that resulted in many applicants. Ford’s assembly employees had supervisors who monitored their work performance and this probably played a role in increased worker productivity (Raff and Summers 59, 1987). In conclusion, this essay conducts the solutions aforementioned, in order to solve the principal-agent problem. These solutions have been proved to be effective to some extent. However, Therefore, future research could further explore the behavioural psychology behind employers as opposed to workers in terms of their thinking and work ethics as these incentives are not always effective which is what is suggested by traditional economics. This is due to the unpredictable nature of human beings.

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