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Ross S 1973 American Economic Review, 63 (2), 134-139.
Ross S 1973 American Economic Review, 63 (2), 134-139.
The relationship of agency is one of the this act, wia, 6), will depend on the random
oldest and commonest codified modes of state of nature dit9, the state space set),
social interaction. We will say that an unknown to the agent when a is chosen.
agency relationship has arisen between two By assumption the agent and the prin-
(or more) parties when one, designated as cipal have agreed upon a fee schedule / to
the agent, acts for, on behalf of, or as rep- be paid to the agent for his services. The
resentative for the other, designated the fee, /, is generally a function of both the
principal, in a particular domain of deci- state of the world, 6, and the action, a, but
sion problems. Examples of agency are we will assume that the action can influ-
universal. Essentially all contractural ar- ence the parties and, hence, the fee only
rangements, as between employer and through its impact on the payoff. This
employee or the state and the governed, permits us to write.
for example, contain important elements
of agency. In addition, without explicitly (1) f=fiwia,B);B).
studying the agency relationship, much of Two points deserve mention. Obviously
the economic literature on problems of the choice of a fee schedule is the outcome
moral hazard (see K. J. Arrow) is con- of a bargaining problem or, in large games,
cerned with problems raised by agency. In of a market process. Much of what we
a general equilibrium context the study of have to say is relevant for this view but
information flows (see J. Marschak and we will not treat the bargaining problem
R. Radner) or of financial intermediaries explicitly. Second, while it is possible to
in monetary models is also an example of conceive of the fee as being directly func-
agency theory. tionally dependent on the act, the theory
The canonical agency problem can be loses much of its interest, since without
posed as follows. Assume that both the further conditions, such a fee can always
agent and the principal possess state in- be chosen as a Dirac 8-function forcing a
dependent von Neumann-Morgenstern particular act (see S. Ross). In some sense,
utility functions, G(-) and [/(•) respec- then, we are assuming that only the payoff
tively, and that they act so as to maximize is operational and we will take this point
their expected utility. The problems of up below. Now, the agent will choose an
agency are really most interesting when act, a, so as to
seen as involving choice under uncertainty
and this is the view we will adopt. The (2) max
agent may choose an act, a^A, a feasible
action space, and the random payoff from where the agent takes the expectation
over his subjectively held probability dis-
* Associate professor of economics, University of tribution. The solution to the agent's
Pennsylvania. This work was supported by grants from problem involves the choice of an optimal
the Rodney L. White Center for Financial Research at
the University of Pennsylvania and from the National act, a", conditional on the particular fee
Science Foundation. schedule, i.e., a''=ai{f}), where a(-) is a
134
VOL. 63 NO. 2 DECISION MAKING UNDER UNCERTAINTY 135
mapping from the space of fee schedules the world than the principal (agent). If we
into A. abstract from this possibility we will have
If the principal has complete informa- to show that we are not throwing out the
tion about the fee to act mapping, a( baby with the bath water.
he will now choose a fee so as to Under this assumption the problem is
considerably simplified but much of inter-
max E{ U[wiai{f}), 6) est does remain. Suppose, first, that we are
(3) simply interested in the properties of
Pareto-efficient arrangements that the
where the expectation is taken over the agent and the principal will strike. Notice
principal's subjective probability distribu- that the optimal fee schedule as seen by the
tion over states of nature. If the principal principal is found by solving (3) and is
is not fully informed about a( •), then a( •) dependent on the desire to motivate the
will be a random function from his point agent. In general, then, we would expect
of view. Formally, at least, by appropri- such an arrangement to be Pareto-in-
ately augmenting the state space the efficient, but we will return to this point
below. The family of Pareto-efficient fee
criterion (3) could still be made to apply.
schedules can be characterized by assum-
In general some side constraints on (/)
ing that the principal and the agent co-
would also have to be imposed to insure
operate to choose a schedule that maxi-
that the problem possesses a solution (see
mizes a weighted sum of utilities
Ross). A market-imposed minimum ex-
pected fee or expected utility of fee by the
agent would be one economically sensible (6) max E{U[W - f] + \G[f]},
constraint:
where X is a relative weighting factor (and
(4) E{G[fiwia,d);e)]}>k. where strategies have been randomized to
e
insure convexity). K. Borch recognized
Since utility functions are assumed to be that the solution to (6) is obtained by
independent of states, 6, one of the im- maximizing the function internal to the
portant reasons for a fee to depend di- expectation which requires setting
rectly on d would be if individual subjective
probability distributions differed. In what (P.E.) U'[w - f] = \G'[f]
follows we will assume that both the agent
and the principal share the same subjective when U and G are monotone and concave.
beliefs about the occurrence of 6 and write (See H. Raiffa for a good exposition.) The
the fee as a function of the payoff only. P.E. condition defines the fee schedule,
/(•), as a function of the payoff w (and the
(5) / = fiwia, 6)). weight, X). (See R. Wilson (1968) or Ross
Notice that this interpretation would for a fuller discussion of this derivation
not in general be permissible if the prin- and the functional aspect of the fee
cipal lacked perfect knowledge of a(-)- schedule.)
More importantly, though, surely aside An alternative approach to finding op-
from simple comparative advantage, for timal fee schedules was first proposed by
some questions the raison d'etre for an Wilson in the theory of syndicates and
agency relationship is that the agent (or studied by Wilson (1968, 1969) and Ross.
the principal) may possess different (better This is the similarity condition that solves
or finer) information about the states of for the fee schedule by setting
136 AMERICAN ECONOMIC ASSOCIATION MAY 1973
We may conclude, then, that the class of an understanding of the agency relation-
payoff structures that simultaneously solve ship will aid our understanding of this
the principal's problem and lead to Pareto difficult question.
efficiency for all {U, G) pairs is quite im- The results obtained here provide some
portant and quite likely to arise in practice. of the micro foundations for such studies.
In general, though, it is clear that the We have shown that, for an interesting
solution to the principal's problem will not class of utility functions and for a very
be Pareto-efficient. This is, however, a broad and relevant class of payoff struc-
somewhat naive view to take. Pareto effi- tures, the need to motivate agents does not
ciency as defined above assumes that per- conflict with the attainment of Pareto
fect information is held by the participants. efficiency. At the least, a callous observer
In fact, the optimal solution to the prin- might view these results as providing some
cipal's problem implied that the fee-to-act solace to those engaged in econometric
mapping induced by the agent was com- activity.
pletely known to the principal. In such a
case it might be thought that the principal APPENDIX
could simply tell the agent to perform a
particular act. The difficulty arises in This appendix solves the partial differen-
tial equation (12) in the text.
monitoring the act that the agent chooses.
Integrating (12) over e yields
Michael Spence and Richard Zeckhauser
have examined this problem in detail in dw . ^ dw
the case of insurance. In addition, if agents + [hia)e -I- cia)] = 0.
are numerous the fee may be the only com-
munication mechanism. While it might in da de
principle be feasible to monitor the agent's
actions, it would not be economically Along a locus of constant w,
viable to do so. = bia)e + cia).
de
da dw/da
dw/de
The format of this paper has been such
as to allow us to only touch on what is is a first order Bernoulli equation that inte-
surely the most challenging aspect of grates to
agency theory; embedding it in a general
equilibrium market context. Much is to 4. J
be learned from such attempts. One would
naturally expect a market to arise in the
where ;fe is a constant of integration. It fol-
services of agents. Furthermore, in some
lows that
sense, such a market serves as a surrogate
for a market in the information possessed wia,e) = H[eBia) - Cia)],
by agents. To the extent to which this
occurs, the study of agency in market where
contexts should shed some light on the Bia) =
economics of information. To mention one
more path of interest—in a world of true and
uncertainty where adequate contingent
markets do not exist, the manager of the Cia)^Je-J ia) -\- k.
firm is essentially an agent of the share-
holders. It can, therefore, be expected that and Hi-) is an arbitrary function.
VOL. 63 NO. 2 DECISION MAKING UNDER UNCERTAINTY 139