Principals and Agents

The principal-agent problem arises when a principal hires an agent to pursue the principal's interests but the agent develops priorities of his/her own.

The problem is found to different extents in all large organisations, including in the way that shareholders and senior executives find it very difficult to ensure that middle managers, foremen etc. work to the corporate agenda as seen from head office. There is a strong tendency for humans to align their goals and behaviour to that of the team or work group around them. As a result, it often seems that corporations are in practice run in the interests of the firm's managers who have grown to regard their firm's economic interests as entirely coincident with their own. (See Note 4 below for a comment on organisational design.)

It is for instance almost universally common for middle managers to focus on what they see as the long term good of their factory, office or other small part of the organisation. When asked to find efficiency savings they will fight hard to retain their budget and their staff numbers. They see no point in implementing all those 'stupid directives from head office, and find record keeping a bore. Boxes are meant to be ticked, whether or not the associated action has been carried out. They will often enter into an implicit bargain with their teams, allowing the use of material for personal ends, providing generous expense accounts, etc. so as to generate a better (non-confrontational) climate within the team - often characterised as 'high morale'. Such teams resist change - especially if it might lead to greater efficiency (working harder and/or job losses).

The problem gets even worse when the organisation's Board of Directors (or equivalent) is formed of out-of-touch mates of the Chief Executive and/or the 'Great and Good'.  The problems at Lehmans are summarised here, and Theranos is another good example:

The company was set up, with the best of intentions, by Elizabeth Holmes who was determined to find a way to make blood testing more convenient for both doctor and patient.  John Carreyrou's book Bad Blood describes how it all went terribly wrong.  He notes that Ms Holmes had recruited the following big names to her Board: George Shultz, James Mattis, Henry Kissinger, William Perry, Sam Nunn and Gary Roughead. "They were men with sterling, larger-than-life reputations who gave Theranos a stamp of legitimacy. ... Elizabeth had methodically cultivated each one of them and offered them board seats in exchange for grants of stock."  Needless to say, none of them had either the knowledge or experience to understand what the company was doing, nor were they inclined to be critical of their apparently fabulous Chief Exec.

It is also the case, of course, that some middle managers are quite weak, and incapable of standing up to staff who are not doing a good or reliable job.

And senior managers often engage in a sort of magical thinking, believing that - by 'banning' something in their organisation - they actually get rid of it, as if they had pointed a magic wand and the 'banned' thing actually disappears in consequence.  Spoiler - it doesn't!

There are two consequences for regulators.

It can therefore be very hard for a regulator to find out what is really happening inside a regulated entity, not least because the entity's own senior executives probably do not themselves know what is happening and, if they do, will be very reluctant to admit their partial loss of control. Much the same applies to compliance officers, whose creation is too often regarded by their Board as a box which has been ticked, and so a good reason to ignore regulatory issues.

It is tempting to assume that the failure of front line staff to comply with safety, financial and other protocols is because they are responding to pressure from above, such as to meet financial or other targets, to complete work quickly, to maintain production etc. However ...  leaders of rule-bending teams may themselves be keen to get through work quickly, and/or to impress seniors with their achievements, or maybe simply to get home on time, or to avoid a small amount of work running over into the next day. It is truly very difficult for regulators and company directors to know that this is happening unless there are robust and unpredictable inspection arrangements backed up by a strong compliance culture, and opportunities for whistle-blowing.

The principal-agent problem also means that regulators need to take into account how the middle and lower reaches of an organisation might react to regulatory pressure. The need for change and/or improvement may be accepted by senior executives, but this does not mean that the necessary changes will be accepted or implemented at the working level. The regulatory intervention needs to be designed with this problem in mind.

Here are some other examples of the principal-agent problem. (Others, which have caused major problems, may be found here.)

And the principal-agent problem is hardly a new one.  CE Montague tells the delicious story, in his book Disenchantment, of the old hand sergeant-major who, instead of taking his young recruits on a long training march, takes them to a pub where they are surprised to find that 'arrangements for serving a multitude are surprisingly complete', and that their sergeant-major is clearly well acquainted with the publican.  I suspect that armies have suffered from, and Generals will have cursed, this sort of problem right back to the beginning of armed conflict.

Notes

See Jean Tirole's Hierarchies and Bureaucracies: On the Role of Collusion in Organizations for a lengthier discussion of the Principal-Agent problem.

It can be argued that the principal-agent problem explains the central issue of organisational design. Although delegating decision-making is an important part of good organisation design, it is of little use unless the decision makers share the organisation’s objectives. That is why incentives are so important. The individual with valuable local knowledge should be incentivised to act as if the objectives of the organisation are his or her own.

 

Martin Stanley

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