Producing too little with positive externalities: Honey

Chapter 17: Principal–Agent Issues and Adverse Selection: Can Everyone Agree?

✓ Principals frequently don’t directly observe the agent’s actions. ✓ The agent’s actions aren’t the sole determinant of the ultimate outcome.

When a company loses a million dollars, was it because of poor managers, or did good managers keep the company from losing two million dollars? Simply looking at the firm’s profit doesn’t provide enough information to tell whether the management is good or bad just like looking at a coach’s record in a given season doesn’t indicate whether the individual is a good or bad coach. Winning half the games with less talented players may indicate great coaching while winning half the games with extremely talented players may indicate bad coaching.

Shareholders in a large corporation, the principals, want to maximize their wealth — the return on their investment. Agents, in this case the firm’s managers, may pursue some combination of other goals, including less effort, higher income, greater job security, lower risk of failure, and better reputation. It’s a difficult challenge to coordinate these various objectives and make them consistent with maximizing the firm’s return on investment.

As principals try to get all employees to work toward maximizing the company’s return on investment or profit, they must determine whether to use sticks or carrots. Sticks focus on supervision and negative consequences such as an employee being fired. The advantage of using sticks is they’re inexpensive to implement. On the other hand, sticks only motivate individuals to a point. That point is the minimum effort necessary to avoid the stick.

On the other hand, carrots focus on rewards. Employees are rewarded for good effort, such as with a profit-sharing plan. The advantage of carrots is employees have an incentive or reward, such as a bonus, for continued hard work past the minimum effort necessary to keep their job. The disadvantage is carrots are expensive.

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Behaving badly with a flat salary

As an absentee owner, you realize your firm’s profit increases as your manager’s efforts increase. You decide to pay your manager a flat salary. Regardless of the manager’s effort, the salary doesn’t change. On the other hand, extra effort is bad for the manager — it’s hard work. Instead of working hard, the manager would rather talk with employees, surf the web, or play solitaire on the company’s computers. These activities give pleasure or utility, while managerial effort is hard and thus gives disutility. The resulting “compensation” for the manager equals the utility that comes from the flat salary minus the disutility associated with extra effort.

Figure 17-1 describes the relationship between managerial effort — measured on the horizontal axis — and the principal’s goal (profit) and manager’s

302 Part IV: Anticipating Surprises: Risk and Uncertainty

goal (utility) — measured on the vertical axis. The solid lines represent the situation from the perspective of the company’s owners, or principals. As managerial effort increases, net revenue increases at a decreasing rate. That is, the curve is rising but becoming flatter. Given the manager receives a flat or constant salary, net revenue minus the manager’s salary also increases at a decreasing rate. So the company’s owners continue to get more and more profit — net revenue minus the manager’s salary — as the manager’s efforts increase. Maximum profit requires the manager’s best effort.

Figure 17-1:

Optimal effort with a flat salary.

The manager faces a different situation as described by the dash-dot lines in Figure 17-1. The pleasure or utility the manager receives from salary is constant because salary doesn’t change. No matter how much effort the manager makes, the salary stays the same. The manager receives no additional reward for greater effort. However, effort is hard — so more effort leads to disutility. The manager would rather be surfing the web as opposed to expending a lot of energy working. Thus, effort results in disutility — instead of pleasure it generates “pain.”