Principal-agent Framework Research Articles

Optimal Organization of Surrogacy Contracts and Underinvestment

We develop a theoretical model of commercial gestational surrogacy in which a childless couple approaches a prospective surrogate, who is willing to gestate for the couple. We use a Principal-Agent framework with continuous effort to argue the following: in presence of limited liability of the surrogate, provision of optimal incentives (under non-contractible effort) is not feasible. Hence, a surrogate facing low outside option and having limited wealth is always found to put in sub-optimal care for the fetus. Put differently, the surrogate cannot be made a residual claimant (cannot be entitled with custody rights of the fetus) and therefore eliciting first best care is never optimal. But this result dramatically changes when the model is cast in discrete effort where inefficiency is likely only when the surrogate faces low outside option whereas we get multiple efficient contracts for higher outside option. Moreover, we see first-best efficient contracts may be implemented even without full transfer of custody rights to the surrogate.

A dynamic principal-agent framework for modeling the performance of infrastructure

This paper presents a novel approach to the problem of infrastructure development by integrating technical, economic and operational aspects, as well as the interactions between the entities who jointly carry out the project. The problem is defined within the context of a Public Private Partnership (PPP), where a public entity delegates the design, construction and maintenance of an infrastructure system to a private entity. Despite the benefits of this procurement method, the relationship between the two entities is inherently conflictive. Three main factors give rise to such conflict: the goals of the public and private party do not coincide, there is information asymmetry between them and their interaction unfolds in environments under uncertainty. The theory of contracts refers to this problem as a principal-agent problem; however, due to the complexity of the problem, it is necessary to recreate a dynamic interaction between the principal (i.e., the public entity) and the agent (i.e., the private entity) while including the monitoring of the infrastructure performance as an essential part of the interaction. The complex relationship between the sequential actions of players and the time-dependent behavior of a physical system is explored using a hybrid agent-based simulation model. The model is illustrated with several examples that show the versatility of the approach and its ability to accommodate the different decision strategies of the players (i.e., principal, agent) and the model of a physical infrastructure system.

Exit, Resistance, Loyalty: Military Behavior during Unrest in Authoritarian Regimes

A few years into the most recent wave of popular uprisings—the Arab Spring—studying regime trajectories in countries such as Syria, Egypt, and Yemen still seems like shooting at a moving target. Yet what has not escaped notice is the central role military actors have played during these uprisings. We describe how soldiers have three options when ordered to suppress mass unrest. They mayexitthe regime by remaining in the barracks or going into exile,resistby fighting for the challenger or initiating a coup d’état, or remainloyaland use force to defend the regime. We argue that existing accounts of civil-military relations are ill equipped to explain the diverse patterns in exit, resistance, and loyalty during unrest because they often ignore the effects of military hierarchy. Disaggregating the military and parsing the interests and constraints of different agents in that apparatus is crucial for explaining military cohesion during such crises. Drawing on extensive fieldwork we apply our principal-agent framework to explain varying degrees and types of military cohesion in three Arab Spring cases: Bahrain, Yemen, and Syria. Studying military hierarchy elucidates decision-making within authoritarian regimes amid mass mobilization and allows us to better explain regime re-stabilization, civil war onset, or swift regime change in the wake of domestic unrest.

Technical Note—Impact of Inventory on Quota-Bonus Contracts with Rent Sharing

We study the impact of limited inventory on optimal sales-force compensation contracts. We adopt a principal-agent framework, characterized by limited liability and rent sharing with the agent. A commonly invoked assumption in the inventory management literature is that the demand distribution satisfies the increasing failure rate (IFR) property. Under this assumption, however, past research has established that a quota-bonus contract—a widely adopted sales-force compensation contract in the practice—cannot sustain in equilibrium. We show that because of demand censoring in the presence of limited inventory (i.e., demand realizations higher than the inventory level are unobservable), a quota-bonus contract is the optimal equilibrium contract, and it exists, even for a demand distribution with the IFR property. Since most well-known distributions satisfy the IFR property, and inventory constraints are operative in many real-world situations, our results significantly extend the scope of the optimality of quota-bonus contracts and underscore the importance of considering the inventory aspect while making sales-force compensation decisions.

Class Actions As Firms

Class action literature is fixated on principal-agent problems—a near-singular focus that has largely been tracked by the courts, which frequently treat the class action mechanism as a Pandora’s box of agency costs. The ascent of the “principal-agent framework” is unsurprising. The divide between class members and class counsel gives rise to a host of classical principal-agent problems: self interested class counsel often have incentives to act contrary to the interests of class members, and class representatives are poor monitors of such behavior. However, the hegemony of this framework can misguide courts, which not only aggressively regulate genuine principal-agent problems, as they should, but also regularly constrain the size and scope of class actions without explaining why doing so mitigates agency costs. That said, the principal-agent framework rests on an often-assumed, important, and inarguable foundation: principal-agent problems arise because class actions separate ownership (litigation interests belonging to class members) from management (class counsel). This Article refracts the frame of analysis by one degree—from the principal agent framework to Coasean firm analysis. Descriptively, the class action is a like firm. Class actions are, like firms, comprised of ownership interests that aggregate to avoid the higher costs of acting alone in the market, cede control to a manager to achieve efficiencies, and operate pursuant to a profit motive. Moreover, like a firm, there is a natural—almost organic—limit to the growth of a class action: it will expand until litigating outside the class action would prove less costly than additional “growth.” This Article’s “firm framework” is consonant with the most useful components of the principal-agent framework—those that rest on the separation of ownership and management—yet breaks with the traditionalist account in important ways.

The role of non-financial measures in controlling myopic activities: the case of hard selling

Using a principal-agent framework, many analytical studies have examined the role of non-financial or additional performance measures in enhancing long-run efforts such as customer service. However, myopic activities that enhance short-term firm performance at the expense of long-term profitability are prevalent across industries (and perhaps nations). Accordingly, the purpose of this paper is to investigate when and how non-financial measures may be used to control such myopic activities. Specifically, we investigate the interaction between a myopic behaviour known as hard selling and a specific non-financial measure (customer satisfaction), often used to measure the customer irritation that results from hard selling. Prior studies suggest that non-financial measures are always a valuable addition because they increase the level of long-run efforts and decrease the (over) reliance on financial incentives. In contrast, we find that non-financial measures may not always be valuable in controlling myopic activities, and when valuable, they may either increase or decrease the reliance on a financial measure such as accounting earnings. In addition, the impact of non-financial measures on myopic activities varies widely, ranging from no impact at all to complete elimination. Overall, these insights enhance our understanding of the role of non-financial measures in controlling myopic activities, in contrast to enhancing long-run efforts.

Local Content Requirements in the Oil and Gas Industry in Developing Countries: The Return of ISI?

In the recent years, a growing number of developing countries are adopting local content (LC) requirements as condition for exploring and developing oil and gas resources in their home countries, with Brazil being a leading example and Mexico as the latest follower. Similar to the Import-Substitution Industrialization (ISI) model, LC creates incentives to the development of indigenous industries by protecting domestic markets against free imports of goods, like drilling rigs, oil platforms and subsea equipment. Given this similarity, it is worth questioning: Is LC a contemporary reenactment of the ISI development model? ISI has been extensively criticized in the literature and most developing countries – including Latin America nations – had abandoned it in the 1990s after market-driven reforms. This paper will highlight the similarities and differences between LC in the resource sector and the historical experience of ISI. Using a principal-agent framework and Hirschman’s concepts from Exit, Voice, and Loyalty, this paper remarks the monitoring and voice capabilities of oil operators in pressuring suppliers over the quality and time to market of the goods used by the oil industry and limit rent-seeking. Drawing evidence from a recent Petrobras corruption scandal, we show how bribe rates differ from LC contracts in comparison to other Petrobras’ projects, using data from 88 projects signed between 2003-2010, worth over $ 30 billion. This paper advances our theoretical understanding of local content as part of the political effects of resource abundance, how it differs from previous industrial policy efforts, and provides corroborating evidence from a rich dataset of corrupt practices.

Ordered Rape

Policy makers and academics often contend that organizational anarchy permits soldiers to perpetrate sexual violence. A recent United Nations report supports this thesis especially with regard to the massive sexual abuse in the Congolese civil war. We challenge the anarchy argument and maintain, based on a principal-agent framework, that opportunistic military commanders can order their soldiers to rape through the use of sanctions and rewards. Our qualitative and quantitative analysis of a survey of 96 Congolese ex-soldiers shows that ordered rape is more likely in organizations where soldiers fear punishment and in which commanders distribute drugs as stimulants.

Increasing rents and incumbency disadvantage

Recent empirical studies have found a incumbency disadvantage in many developing democracies, in marked contrast with the well-known incumbency advantage in the US and other developed democracies. We know considerably less about incumbency disadvantage than incumbency advantage. In a simple principal-agent framework, I explore the role of a prominent feature of developing democracies – corruption. When rents are constant in incumbents’ tenure – a standard assumption – the conditions for incumbency disadvantage are existent but limited; however, increasing rents, possibly due to learning, a gradual build-up of rent-extraction networks or fiscal windfalls, considerably increase the possibility of incumbency disadvantage, because voters may prefer inexperienced and unconnected challengers, even if they are of lower quality. Incumbency disadvantage becomes more likely as the pace of rent increase grows, politician quality decreases, with noise in the policy outcome, and potentially even when the pool of politicians improves. It is strictly more costly than any electoral outcome with high but constant-rents. The results highlight a novel reason for control of corruption and sensitivity to its dynamics.

Agency problems and interest representation: An empirical analysis of the costs of lobbying

Most recent work on the politics of interest representation assumes that lobbyists represent their clients’ interests with fidelity. We test the validity of this assumption. Relying on a principal-agent framework developed by Stephenson and Jackson, Kersh and Lowery and Marchetti, we first discuss the nature of agency problems in lobbying and the utility of several potential solutions for those problems. We next develop and test two sets of hypotheses on how agency problems might influence one form of lobbying behavior – the prices contract lobby firms charge their interest organization principals. The hypotheses are tested with a purposive sample of clients employing major contract lobby firms operating in Washington DC in 2012.

Teaming Up for Sustained Performance: A Repeated-Game Model of Voluntary Horizontal Collaboration

This paper presents a model to characterize the dynamics of and rationale for voluntary horizontal collaborations commonly seen in global supply chains and organizations. Examples of such collaborations include supply clusters, supplier alliances, and teams of peers within organizations. The model consists of two key elements. One is a repeated game framework that captures the dynamics of the underlying environment, such as the long-term interactions between individual players who have limited capabilities and face uncertain demand. The second element is a peer help mechanism, which articulates the implicit short-term cost and long-term benefit of team production and generate synergies among the players. Our analysis shows that the emergence of horizontal collaborations depends on the difference between the individual players’ productivity levels, players’ patience, and the prevalence of high performers on the team. We also show that equilibrium team size is determined by the cost/technology structure of the collaboration, which varies depending on what kind of asset (e.g., inventory or capacity) is shared. We further extend the model to a principal-agent framework, in which the principal can benefit from forming teams of agents but cannot enforce or monitor whether peer help occurs. Finally, we characterize the optimal compensation and team structure for the principal to assign agents to teams.

The Effects of State Pharmacy Drug Product Selection Laws on Statin Patient Generic-To-Branded Drug Switch-Backs

Brand-to-generic drug therapeutic substitution effects on patient health is an important health policy issue. State pharmacy drug product selection (DPS) laws allow pharmacists to more easily switch prescriptions from brand-to-generic drugs. This research measures the effects of DPS laws on statin-patient generic-to-branded drug switch-backs, this being a potential indicator of clinical failure from the initial brand-to-generic substitution. Anonymized patient-level data from 2006–2008 were analyzed on statin drug utilization patterns for 397,111 U.S. patients. Logistic regression results on DPS and non-DPS variables show effects on switch-backs in a manner consistent with implications from a principal-agent framework in healthcare. DPS laws should be reviewed to ensure that drugs dispensed by pharmacists are those intended by physicians and in the best health interests of patients.

Asymmetric Information, Externalities and Incentives in Animal Disease Prevention and Control

AbstractIncentives influence behaviour while an understanding of farmer behaviour facilitates the control and prevention of infectious livestock disease. This paper lays out several perspectives on how information problems and other externalities affect biosecurity incentives. We use the principal–agent framework to examine livestock disease management in the presence of potential moral hazard and adverse selection. Moral hazard may apply to biosecurity decisions while adverse selection may apply to disease reporting. The example of compensation policies illustrates the importance of creating appropriate incentives: compensation must be sufficient to ensure early reporting but not so large as to discourage appropriate levels of biosecurity effort. Other cases of externalities are more diffuse than those modelled using principal–agent analysis, placing emphasis on third‐party effects and coordination problems. Three examples are provided. One concerns free‐riding when facing an endemic disease pool that can be managed by limiting sources and flows. Another regards coordination failure when securing against an exotic disease where farmer efforts complement and communicating actions are important. The last arises from absence of a risk market where an adverse infrastructural support externality could be managed by disease outbreak insurance.

Optimal Contracts with Random Auditing

In this paper we study an optimal contract problem under moral hazard in a principal-agent framework where contracts are implemented through random auditing. This monitoring instrument reveals the precise action taken by the agent with some nondegenerate probability r, and otherwise reveals no information. We characterize optimal contracts with random perfect monitoring under several information structures that allow for moral hazard and adverse selection. We evaluate the effect of the intensity of monitoring, as measured by r, on the value of the optimal contract. We show that more intense monitoring always increases the value of a contract when the principal can commit to make payments even if the an evaluation reveals that the agent took an action not allowed by the terms of the contract. When such commitment is infeasible and in equilibrium the agent shirks under some realizations of his type, the value of a contract may decrease in r.

Incentives and management styles

In a principal-agent framework, we explain different managing styles. In our model, there are two vertical tasks — an upstream task for improving the project's potential environment, and a downstream task for implementing the project. The downstream task must be done by the worker, but the upstream task can be done by either the manager or the worker. An effort for the upstream task is a hidden action of the party in charge of the task. The realized project environment is the manager's private information. We show that, when the upstream task is easy, the manager may assign the task to herself, even if her opportunity cost is larger than the worker's (a bias in favor of micro-management). When the upstream task is hard, by contrast, the manager may assign the task to the worker, even if her opportunity cost is smaller than the worker's (a bias in favor of macro-management). We also discuss distortions in the project output schedules in each case to show that the central trade-off is efficiency in task allocation versus efficiency in project output.

Class Actions as Firms

Contemporary class action literature is dominated by discussions of principal-agent problems. This singular focus has largely been tracked by the courts, which collectively treat the class action mechanism as a Pandora’s box of principal-agent problems via aggressive interpretation and application of Federal Rule of Civil Procedure 23 (“Rule 23”). The ascent of the “principal-agent framework” is unsurprising. The divide between class members and class counsel gives rise to a host of classical principal-agent problems: self-interested class counsel often have incentives to act contrary to the interests of class members, and class representatives are poor monitors of such behavior. However, the singular hegemony of this framework has misguided courts, which, searching only for principal-agent problems, rarely find anything but what they are looking for. Within this framework, all class action issues are construed as principal-agent problems. This has had a deleterious effect on doctrine — not only are principal-agent problems aggressively regulated, as they should be, but courts also constrain the size and scope of class actions without a clear sense of why doing so is necessary or in fact relates to constraining agency costs. That said, the principal-agent framework does rest on an important, but often unstated, foundation: principal-agent problems arise because class actions separate ownership (litigation interests belonging to class members) from management (class counsel). Turning on this observation, this Article refracts the frame of analysis by one degree — from the principal-agent framework to Coasean firm analysis. In so doing, it advances both a descriptive hypothesis and several doctrinal entailments that follow. Descriptively, the class action is — or, more accurately, should be analyzed as — a firm. Like firms, class actions are comprised of collective ownership interests that aggregate to avoid the higher costs of acting alone in the market, cede control to a manager, and organize around a profit-driven motive. And, importantly, like a firm, there is a natural — almost organic — limit to the growth of a class action: it will expand until litigating outside of the class action would be less costly than additional growth. This Article’s new “firm framework” is both consonant with the most-accurate components of the traditionalist principal-agent framework — those that implicitly rest on a divide between ownership and management — and breaks with the traditionalist account in important ways. Principally, its refraction permits an approach that is not singularly focused on the problems that class actions foster, enabling it to more usefully guide judicial practice. Dovetailing from this new framework, this Article articulates numerous doctrinal entailments that follow, touching on several areas of critical importance to class action practice and procedure. Critically, because class actions have heretofore been constructed exclusively as vehicles for principal-agent problems, Rule 23 has been construed exclusively as a means of mediating such problems. Instead, per the firm framework, courts should consider the various issues that class actions present along two tiers of analysis, discerning between principal-agent problems that demand judicial regulation and those efficiency-related issues that are self-regulating and beyond courts’ core competencies. This doctrinal overlay — which prescribes both a piercing judicial review of questions relating to internal governance of the class action, on the one hand, and a business-judgment-rule-like deference to questions relating to the external boundaries of class actions, on the other — both endorses and critiques status quo doctrine. Specifically, courts should apply a heavy hand when principal-agent problems are likely to be severe and costly, but proceed with a light touch when such problems are largely self-regulating. Several strains of extant class action doctrine “fit” within this two-tiered approach to Rule 23, but the firm framework also calls for considerable doctrinal change. This Article proceeds in four parts. First, it outlines the status quo dominance of the principal-agent framework. Second, it offers a new competitor — the firm framework — explaining both its contours and why it better resonates with the nature of the class action mechanism. Third, it canvasses several doctrinal entailments that follow, specifically calling for considerable change in how courts address questions concerning commonality and predominance. Fourth and finally, it presents a unique model to demonstrate how the firm framework assures that class counsel — even when regulated with a mere light touch — will self-regulate and make the “right” market-based decisions.

Primary Education in West Bengal – A Case of Moral Hazard

There has been a gross inefficiency in the delivery of primary education in the developing countries like India and the situation has continued to remain so for a long time. Though there has been political willingness in recent times to correct the imbalance the situation continues to be grim. One possible reason for this can be that stakeholders are not sufficiently empowered so that effective intervention on their part is not forthcoming. Also it may be possible that adverse incentives on part of the agents are creating a moral hazard problem which is perpetuating this inefficiency. In India the problem is more serious as an overwhelming majority of people has to depend on state run education system where education is a social good and normal market principles are quite ineffective here. The paper tries to look at the problem from the stakeholders’ point of view. With the help of some game theoretic tools we build up a model accompanied by some empirical evidences in support of the model where we try to understand the whole matter in a Principal-Agent framework.

Discretionary Authority and Prioritizing in Government Agencies

Government agencies typically have a certain freedom to choose among different possible courses of action. This paper studies agency decision-making on priorities in a principal-agent framework with multi-tasking. The agency head (the principal) has discretion over part of the agency's budget to incentivize his staff (agents) in the pick-up of cases. The head is concerned with society's benefits from the agency's overall performance, but also with the organization's public image as formed from its case record and various non-case specific activities. Based on their talent and the contracts offered by the head, staff officials choose which type of task to pursue: complex major, yet difficult to complete cases with an uncertain outcome, or basic minor and simple cases with a much higher probability of success. The size of the agency's discretionary budget influences no t only the scale, but also the type of tasks it will engage in. Social welfare is non-monotonic and discontinuous in the agency's budget. Small changes in the budget may cause extensive restructuring from major to minor tasks, or vice versa. A budget cut can improve welfare more than extra budget would, even if resources are below the welfare-maximizing level. For lower binding budgets, the head continues to suboptimally incentivize work on complex tasks, when the agency should have shifted down to simpler tasks. Yet a reluctant head may need to be nudged with more resources to pursue productive cases. In determining the discretionary space of the agency head, government can limit the extraction of resources, but thereby also benefits less from the head's expertise. Antitrust authorities serve as one illustration of policy implications for institutional design.

The Role of Royalties in Resource Extraction Contracts

The manner in which governments charge mineral resource producers has been the subject of considerable debate. In particular, there is a continuing debate about whether royalties should be reduced or eliminated, the preferred alternative then being some variant of an income-based charge such as a resource rent tax, a policy adopted in Norway, the United Kingdom and Australia. The argument for avoiding royalties is based on analyses demonstrating that royalties and other quantity-based charges distort production decisions and lead to outcomes such as high-grading and premature mine closure. We argue that it is inappropriate to infer that royalties are inefficient from the perspective of the resource owner (typically a government on behalf of society). Rather, the royalty serves a key pricing purpose and should be interpreted as the capital loss on the resource owner's balance sheet from extracting marginal reserves. We demonstrate this result under various conditions of uncertainty and informational asymmetry, using an incentive-based framework which enables us to highlight the separation of asset ownership from asset use. The principal-agent framework is consistent with the contracting problem encountered by governments who as resource owners contract with private sector firms for extraction rights.

Discretionary Authority and Prioritizing in Government Agencies

Government agencies typically have a certain freedom to choose among different possible courses of action. This paper studies agency decision-making on priorities in a principal-agent framework with multi-tasking. The agency head (the principal) has discretion over part of the agency's budget to incentivize his staff (agents) in the pick-up of cases. The head is concerned with society's benefits from the agency's overall performance, but also with the organization's public image as formed from its case record and various non-case specific activities. Based on their talent and the contracts offered by the head, staff officials choose which type of task to pursue: complex major, yet difficult to complete cases with an uncertain outcome, or basic minor and simple cases with a much higher probability of success. The size of the agency's discretionary budget influences not only the scale, but also the type of tasks it will engage in. Social welfare is non-monotonic and discontinuous in the agency's budget. Small changes in the budget may cause extensive restructuring from major to minor tasks, or vice versa. A budget cut can improve welfare more than extra budget would, even if resources are below the welfare-maximizing level. For lower binding budgets, the head continues to suboptimally incentivize work on complex tasks, when the agency should have shifted down to simpler tasks. Yet a reluctant head may need to be nudged with more resources to do cases. In determining the discretionary space of the agency head, government can limit the extraction of resources, but thereby also benefits less from the head's expertise. Antitrust authorities serve as one illustration of policy implications for institutional design.