Insight into Principal agent theory
Governments now use a number of principal-agent or funder-provider type models to deliver policy or provide services (both between governments and from governments to the community). Why were these models chosen, what has been the effect and what are the strengths and weaknesses of such models?
Next section outlines agency theory as it has applied in private markets and the role of transaction costs. The emergence of public choice theory when combined with agency transaction costs theory and
Principal-agent theory was initially developed within the economics discipline to better understand and resolve dilemmas associated with so called ‘information asymmetries’ between two sets of players – principals and agents – who frequently have divergent motivations, goals and attitudes to risk. A necessary assumption required for the theoretical ideal of perfect competition is perfect information between buyers and sellers in an exchange. As economists readily attest, this assumption rarely holds in reality, providing an avenue for opportunistic behaviour where one party to a transaction – the agent – has an information advantage over the other – the principal.
The agent is employed or contracted by the principal to provide a good or service that has some value, for which the agent is remunerated by the principal. The problem is in essence a contracting problem concerning how much of the value created should go back to the agent by way of remuneration (Lane,2003a:2). Due to asymmetric information the agent knows more than the principal about the desired good or service required, providing prospect for self-interest-motivated opportunistic behaviour on the part of the agent. This gives rise to two distinct problems for the principal:
Adverse selection which occurs where goods and services being bought are not of the quality expected (for example, sellers of used cars behave opportunistically by not revealing known defects unobservable to the buyer) or may involve misrepresentation of ability by the agent (such as overstating experience or qualifications at a job interview); and
Moral hazard whereby information agents possess cannot be monitored or challenged providing an incentive to behave either dishonestly or in ways which might not provide the full benefit to the principal (for example, once insured, a car owner might take more risks as a driver or less care in ensuring the vehicle is securely parked and locked).
Thus adverse selection is a pre-contractual problem requiring effort on the part of the principal in discovering the suitability of the agent prior to forming a contract whereas moral hazard occurs after the contract has been made requiring monitoring of effort and performance of the agent during the contract period. Principals, in addressing both these problems, incur ‘transaction costs’ associated with selecting appropriate agents, negotiating contracts and in monitoring and evaluating performance and delivery. Such costs lead to economically inefficient outcomes and are a source of potential market failure.
However principals know they are at an information disadvantage so utilise a variety of incentives in an attempt to align the interests of the agent with their own, such as commissions, profit sharing and efficiency wages. In contract negotiations this typically involves specifying an ‘outcome-oriented contract’ (Shapiro, 2005:265) combining elements of monitoring and motivation designed to minimise the transaction costs encountered by the principal, while maximising the value generated to both parties.
Contestability within markets – that is competition or the threat of competition – can also assist with alignment of interests, minimising opportunistic deviation from stated goals and minimising transaction cost. As Skoussen (2008: 64) observes, private firms ‘compete in order to collaborate.’ That is competition at each stage of the production process, or ‘intrastage competition’ can align interest of providers who have a vested interest in gaining certainty for the sale of their own productive output through a guaranteed buyer, providing them some assurance in making necessary longer-term business investment decisions . Principals, in drawing up contracts, can thus utilise competition among agents since their interests will often be more congruent with those of the principal (Shapiro ..).
Transaction costs represent a kind of ‘economic friction’ which reduces efficiency of the market but does not necessarily result in market failure. Transaction cost analysis is based on the efficiency concept that it is the cost of transacting business that determines organisational structure. Firms either ‘make or buy’ intermediate inputs to their production processes based on an assessment of the relative costs, associated with outsourcing an activity (including risk of a botched job or sub-standard quality etc) versus performing the task oneself. Thus a firms structure is determined by comparative costs of these make or buy decisions.
While the nature of agency problems and transaction costs dictates that the value generated under a contractual arrangement will be sub-optimal or a second-best solution when compared to the theoretical ideal of a ‘free market’, the principal-agent relationship is nevertheless beneficial to both parties. And more efficient than monopoly provision
Application to the Public sector
Why in the PS - history
The emergence of public choice theory and New Public Management in the UK ( ) new institutionalist economics in NZ ( ) and Reinvented government in the US (Ferris and Graddy, 1996) that led to the application of principal-agent theory to the public sector
The rise of the welfare state in the post-war decades coupled with a principles of universal access and provision through government run monopolies and nationalised industries resulted in growing dissatisfaction with the bureaucratic service delivery model which was seen to have become ‘monolithic, authoritarian, paternalistic, inflexible and slow’ (Wanna, et. al. 2010:24).
Following initial moves by the Thatcher government to privatise public assets in the UK ation – realisation that competition not ownership (whether public or private) led to greater resource allocation
Why in the PS - rationale
NPM reforms have several key features including: letting public sector managers be ‘free to manage’; setting explicit standards and measures of performance; placing greater emphasis on results or outputs rather than procedures or inputs; the disaggregation of units in the public sector; a shift to greater competition in the public sector; emphasis on private sector styles of management (Hood, 1991) – in Hood’s view NPM represents ‘a marriage of two different streams of ideas’ – the new institutional economics (built on public choice theory, transactions cost theory and agency theory) and business-type managerialism. The adoption of NPM in different countries
Althaus (1997) analyses the way that agency theory has underpinned public sector reform in the UK and New Zealand – she advances some significant reservations about the extent to which theories of private exchange can be applied to public sector activities
Appreciation of the power and limits of the principal-agent model gained by understanding its relationship with public choice theory, transaction cost analysis and property rights theory.
Public choice theory
Public choice theory argues that public servants often act in their own self-interest and may work against the public interest in order to protect or inflate their budgets and resources. This theory highlights a principal-agent problem whereby political principals are at an information disadvantage and face potential moral hazard in overseeing the activities of bureaucratic agents (Moe, 1984; Gains and John, 2007).
Proponents of public choice theory
Public choice linked to capture where “… an agency whose existence is inextricably linked to the continuation of existing policy is likely to be biased in favour of existing policy – that is, the agency is ‘captured’ (Treasury 1987: 75) –recommended solutions to public choice include minimising the role of the state, reducing public monopolies, contracting out and organisational separation of roles to overcome such capture.
A premium has been placed on getting better return on public sector resources – New Public Management (UK) and reinventing government (US) –Applied where in the PS
A range of models and reforms have been implemented around the globe in response to agency theory. Purchaser-provider separation (Aulich, 2002; Steffens et.al 1998; Street 1994), compulsory competitive tendering (Aulich, 1999), decentralisation of fiscal relationships (Tommasi and Weinschelbaum, 2007) and performance contracts and performance-based budgeting (Ferris and Graddy, 1996) are all synonymous with potential principal-agent problems.
Who is the principal
who is the principal? Only in countries with democratically elected governments is it true that the principal is the citizenry and the elected government the principal.
Lane looks upon politics as a succession of principal-agent games, starting with the electoral contract, i.e. of voting in a new national assembly and government in order to end up in the setting up of implementation agencies working under a contract with government. Thus, politics is basically contracting, which raises the issues of consideration and quid pro quo, which issues tend to be resolved differently in democracies on the one hand and authoritarian regimes on the other hand. Yet, all politics involves contractual opacity and the serious risk of a mismatch between promises and outcomes, due to the long intertemporal nature of the electoral or administrative contracts
Ultimately consumers have no effective sanction over purchaser behaviour, and given that consumers cannot easily vote with their feet, there are few incentives for purchasing authorities to be innovative and responsive to consumer preferences (Street, 1994, p.7)
Steffens et.al (1998) purchaser-provider structures adopted in QDPI as a means of introducing competition and increasing accountability and transparency in the delivery of services – rate relative success as due to the establishment of a business-to-business network with a mix of cooperation and competition, rather than competition alone.
Hagan and Bredt (2009), the reforms to date have largely focused on the producer-side of the market with emphasis on increasing competition and cost minimisation. There has been much less consideration given to consumer (including industry) behaviour and the intended outcomes of vocational training. In short, expenditure on vocational education and training has been considered a cost to be minimised rather than an investment in human capital to be maximised
Multiple principals – cross jurisdictional boundaries – restrictions imposed on states by Commonwealth - VET reforms State Purchaser as agent of the Commonwealth government is principal to state based training providers – different rules and incentives apply to the different funding streams
Street (1994) examined then proposed p-p separation arrangements aimed at correcting structural inadequacies in the national health system.