Solutions to Principal-Agent Problems in Firms

There are many settings in which one economic actor (the principal) delegates authority to an agent to act on her behalf .T h ep r imary reason for doing so is that the agent has an advantage in terms of expertise or information. This informational advantage, or information asymmetry, poses a problem for the principal—how can th ep rincipa lb e sure that the agent has in fact acte di n her best interests? Can a contract be written defining incentives in such a way that the principal can be assured that the agent is taking just the action that she would take, had sh et he information availabl et o the agent? Solving this problem is a matter of some concern for patients dealing with their doctors, clients dealing with their lawyers, or celebrities dealing with their publicists. It i sa lso a crucial concern for business firms dealing with their employees. Especially in the twenty-first century, employees are often hired precisely because they have information availabl et hat is unavailabl et o t he managers of a firm. Making sure that employee expertise is put to wor ki nt he interest of the firm can make the difference between success and bankruptcy–as illustrate db yt h er elative performance of Southwest Airlines compared to much of the rest of the airlines industry. This paper examines the large principal-agency literature as it relates to management patterns i nt he firm. A powerful conclusion emerges, not from any one segment of the literature as much as from a bird’s-eye view of the literature as a whole, that there is no unique “solution” to the principal-agent problems in a firm. Instead, a Coasean “contingency” theory can be constructe di nw hich different conditions inside the firm (characterized by production technology, severity of information asymmetry, and relative risk-preferences of principals and agents) call for different “solutions” to th ep rincipal-agent problems. While the first significant papers in principal-agency theory were developed independentl yo f Coasian theory, thi sc hapter of the Handbook will try to establish that there is a natural connection between the two. Coase (1937) hypothesized that transactions may be structured in different ways—in particular, some can be better managed via hierarchy within a firm rather than b yt he market between firms. This insight has led, in recent years, to a larg ea nd successfu ll iterature on the “boundaries of the firm”—examining when transactions are best