Producing too much with negative externalities: Pollution

300 Part IV: Anticipating Surprises: Risk and Uncertainty

In this chapter, I focus on the problems created by differences in individual goals and asymmetric information and how to overcome these problems. You discover how incentives help convince individuals with different goals to work toward a common objective. In situations where somebody doubts the accuracy of your statements — “I only drove this ten-year-old car to church on the months with five Sundays” — I show you how to make a persuasive, true argument. (I’m not teaching you how to lie. I’m teaching you how to convincingly tell the truth.) In situations where you have less information and doubt another’s claims, I explain how you can get the individual to reveal the information he or she possesses. And finally, you discover the hazard of your actions inadvertently changing individual behavior and how to prevent those changes. Indeed, this is a very informative chapter on information.

Principal–Agent Problem #1: When Managers and Owners Disagree

Incentives matter. If you disagree, have you ever been bribed to eat your vegetables with the offer of dessert? If you have and you ate your vegetables, you know incentives matter.

Businesses are comprised of many individuals who possess different goals. Principals are the ultimate recipient of a situation’s outcome. In the case of a business, the firm’s principals are its owners and the ultimate outcome they receive is profit. Agents serve as the principal’s representatives and make decisions on the principal’s behalf. In a business, agents include the managers and workers.

The principal–agent problem exists when the agent’s objectives differ from the principal’s objectives.

Recognizing that incentives matter isn’t enough for owners and managers. Different employees of the firm with different jobs ultimately have to work for the same thing — maximum profit. Therefore, it’s important to establish incentives that result in a coordinated, cooperative effort to maximize profit. Incentives must make objectives complementary or identical and eliminate the principal–agent problem. The challenge is to accomplish this task given individuals have different interests and preferences.

The principal–agent problem is especially evident when the agent’s effort isn’t observable or measurable.

Contributing to the principal–agent problem is the lack of information. It’s difficult to know how much effort an employee makes unless you sit and watch the employee all the time — but that in and of itself is very unproductive. In general, two major issues contribute to the principal–agent problem: