Agency Theory

Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. Most commonly, that relationship is the one between shareholders, as principals, and company executives, as agents. An agency, in broad terms, is any relationship between two parties in which one, the agent, represents

Decision Theory

Decision theory (or the theory of choice not to be confused with choice theory) is the study of an agent’s choices. Decision theory can be broken into two branches: normative one, which analyzes the outcomes of decisions or determines the optimal decisions given constraints and assumptions, and descriptive one, which analyzes how agents actually make the decisions they do. Normative decision theory

Theory of Organizational Power

Max Weber (1947) in his classical organization theory exemplified power in an organization through the process of control. Weber related authority to legitimacy, implying that managers enjoy it by virtue of their position in the organizational hierarchy. Although legitimate authority itself is a power, an individual member of an organization without authority can also

Theory of Organizational structure

An organizational structure defines how activities such as task allocation, coordination, and supervision are directed toward the achievement of organizational aims. According to the Theory of Organizational structure, organizational structure affects organizational action and provides the foundation on which standard operating procedures and routines rest. It determines which individuals get to participate in which decision-making processes, and thus

Property Rights Theory

In the property rights theory, property rights are basic human rights, grounded in current Human Rights law as found in article 17 of The Universal Declaration of Human Rights and theoretical constructs in economics for determining how a resource or economic good is used and owned. This idea of ownership must be constrained from the views of absolute

Theory of the Visible Hand

The theory of the visible hand of Alfred D. Chandler determined that it was not the invisible hand of the market that determined corporate effectiveness but the visible hand of management. His book, “The Visible Hand: The Managerial Revolution in American Business,” which won both the Pulitzer and Bancroft prizes in 1978, rewrote the

Incentives of agency theory – Adam Smith and Incentive Contracts in Agriculture

In his discussion of the determination of wages, Adam Smith (1776, bk. 1, chap. 7) recognized the contractual nature of the relationship between the masters and the workers. He asserted the conflicting interests of those two players and recognized that the bargaining power was not evenly distributed between them; the masters generally had all

Incentives of agency theory – Chester Barnard and Incentives in Management

As we saw above, Smith (1776) already discussed the problems associated with piece-rate contracts in the industry. Babbage (1835) went a step further by under- standing the need for precise measurement of performances to set up efficient piece-rate or profit-sharing contracts: It would, indeed, be of great mutual advantage to the industrious work- man,

Incentives of agency theory – Hume, Wicksell, Groves: The Free-Rider Problem

Hume (1740) may be credited with writing the first explicit statement of the free- rider problem: Two neighbours may agree to drain a meadow, which they possess in common; because it is easy for them to know each others mind; and each must perceive, that the immediate consequence of his failing in his part,

Incentives of agency theory – Borda, Bowen, Vickrey: Incentives in Voting

Since the beginning of the theory on voting, the issue of strategic voting was noticed. Borda (1781) recognized it when he proposed his famous Borda rule: My scheme is only intended for honest men. We have to wait for Bowen (1943) to see a first attempt at addressing the issue of strategic voting. For

Incentives of agency theory – Léon Walras and the Regulation of Natural Monopolies

Walras (1897) defined a natural monopoly as an industry where monopoly is the efficient market structure and suggested, following Smith (1776), to price the prod- uct of the firm by balancing its budget. This led to the Ramsey (1927) and Boiteux (1956) theory of optimal pricing under a budget constraint. After some price cap

Incentives of agency theory – Knight, Arrow, Pauly: Incentives in Insurance

The notion of moral hazard, i.e., the ability of insured agents to affect the proba- bilities of insured events, was well known in the insurance profession.15 However, the insurance writers tended to look upon this phenomenon as a moral or ethical problem affecting their business. Arrow (1963b) introduced this concept in the economic literature

Incentives of agency theory – Sidgwick, Vickrey, Mirrlees: Redistribution and Incentives

The separation of efficiency and redistribution in the second theorem of welfare economics rests on the assumption that lump-sum transfers are feasible. As soon as the bases for taxation can be affected by agents’ behavior, dead-weight losses are created. Then raising money for redistributive purposes destroys efficiency. More redistribution requires more inefficiency. A trade-off

Incentives of agency theory – Dupuit, Edgeworth, Pigou: Price Discrimination

When a monopolist or a government wants to extract consumers’ surpluses in the pricing of a commodity, it faces in general the problem of the heterogeneity of consumers’ tastes. Even if it knows the distribution of tastes, it does not know the type of any given consumer. By offering different menus of price-quality or

Incentives of agency theory – Incentives in Planned Economies

We must distinguish between the Soviet practice and the theory of planning devel- oped in the Western countries. As explained by Berliner (1976), In the early years of the Soviet period there was some hope that socialist society could count on the spirit of public service as a sufficient motiva- tion for economic activity.

Incentives of agency theory – Leonid Hurwicz and Mechanism Design

When general equilibrium theorists attempted to extend the resource allocation mechanisms to nonconvex environments they realized that new issues of commu- nication and incentives arose: In a broader perspective, these findings suggest the possibility of a more systematic study of resource allocation mechanisms. In such a study, unlike in the more traditional approach, the

Introduction to The Rent Extraction-Efficiency Trade-Off

Incentive problems arise when a principal wants to delegate a task to an agent. Delegation can be motivated either by the possibility of benefitting from some increasing returns associated with the division of tasks, which is at the root of eco- nomic progress, or by the principal’s lack of time or lack of any

The Rent Extraction-Efficiency Trade-Off: The Basic Model

1. Technology, Preferences, and Information Consider a consumer or a firm (the principal) who wants to delegate to an agent the production of q units of a good. The value for the principal of these q units is S(q) where S’ > 0, S” < 0 and S(0) = 0. The marginal value of the good is

The Complete Information Optimal Contract

1. First-Best Production Levels  First suppose that there is no asymmetry of information between the principal and the agent. The efficient production levels are obtained by equating the principal’s marginal value and the agent’s marginal cost. Hence, first-best outputs are given by the following first-order conditions and The  complete  information  efficient  production  levels  q∗

Incentive Feasible Menu of Contracts

1. Incentive Compatibility and Participation Suppose now that the marginal cost θ is the agent’s private information and let us consider the case where the principal offers the menu of contracts {(t*, q*); (t¯*, q¯*)} hoping that an agent with type θ will select (t*, q*) and an agent with type 6 will select