g ~ Agency

With Eric Posner

Think abou t situations where one pers

on is supposed to work hard for
the benefit of another. The obvious exam
ples involve people hired to
do things: the lawyer is supposed to work
hard for the client; the real
estate agen t is supposed to work hard
for the seller of the house. But
sometimes the same problem arises whe
re the relationship is less direcL
A company 's stockholders want the offic
ers runn ing it to work hard , and
voters want the politicians they elect to work
hard. Toe general structure
of ali these situations nevertheless can
be considered similar. First there
is a pers on called a prin cipa l-a clien
t, a boss, or a citizen; and then
there is an age nt-a lawyer, an employe
e, or a poli ticia n-w ho is sup-
posed to be working to advance the prin
cipal's interests. But there is a
natural conflict of inter est between them
. The agent doesn't feel al1 the
benefits he creates by working hard; the
benefits of his work go, at least
immediately, to the clien t, to the boss,
or whoever else he is serving. So
the agent, having no love ofha rd work
for its own sake , would prefer not
to work so hard . He would prefer, in a
word , to shirk.
The shirking wouldn't be a problem if
the principal coul djus t pay the
agent acco rdin g to his efforts, so that
the hard er the agent works, the
more mon ey or othe r benefits he gets . The
trouble comes when the prin-
cipal can' t exactly tell how hard the agen
t is working. Sometimes al1 the
principal clearly sees are the results of
the agent's labors, and they might
be hard to inte rpre t; he mig ht not be sure
whe ther a bad outcome is the
result of the agen t's poo r efforts or of
something else. The owner of the
seafood resta uran t won ders if he is losin
g business because nobody likes
his waiters or beca use nobo dy likes his fish.
Shareholders wonder whether
the value of a com pany 's stock has gone
down because the CEO is inep t
or because of com peti tion from overseas.
It's hard to know for sure.
Principals need ways to reassure themselve
s that thei r agents will work
hard whe n they aren 't bein g watc hed,
whe ther because watching them is
impossible as a prac tica! mat ter or too
expensive to be worth the bother.
People who wou ld like to be agents will
want those mechanisms to exist,
too; for if they have no way to reassure
thei r principals, they will have
trouble find ing wor k or gett ing paid as
muc h as they would like. (Agents
 RUST , c oOPE R ATIU N , ANO
88 PA RT 11 , T OTH ER PR
O 8 l EMS
. ome insu ranc e agai nst the chan ce of had
also will want s
. c lt· we will com e b ac k to th'
aren 't their iau • 1s.) The expe n outcolb.es th
al ofwa tc h m . g the agen t, and the expe nse to the agen t sef to .the Prin,.;at Chapttr 9. Ag,my Bg
. When good results do occu r. Those, in general terms
p
re the pnnc 1 , . •pal are know n to thos e with a taste for eo lrying ~,- . , are the movm .
conon to reas,. parts in a typ1cal contr act mean t to solve an g
su i.¡ . agency problem. Let's look
agency cos ts. Also rega rded as agen cy costs . .are the losses th e Jargon at some examples of how they get arranged.
as th effor ts fail: the losse s from sh1r
when all ose ' king or corru . at 0<:cur Start with the waiters at a restaurant. Assume,
, ·nter ests aren t qmte . . . Ption be plausibly, that the suc-
the agen t s i ahgn ed with the princ ipal' cause cess of a resta uran t depe nds partly on how
th d b hard the waiters work and
. that neve r get off e grou n ecau se the need s,d and the partly on various othe r things. If the waiters
are lazy, the restaurant is
ente rpns es
trost betw een
.
princ ipal and agen t can' t be estab lishe
d at a1tB leve\ of
· Ut th
doom ed; if the wait e~ work har~, the resta
urant may do well if various
are mter esun g ways in whic h the prob lems of prin cipa l and
. othe r things also go nght . Cons1der why sorne
ere of the obvious contrac-
agent oft tual soluú ons here woul dn't work. The owne
do get solve d or at least kept und er cont rol, usua lly with the h en r could pay each waiter a
. . . e1P ofle....1 lot if business is good and noth ing otherwise.
mechan1s ms. Thos e solu tions are the subJ ect of th1s chap ter ""' that they will make mone y only if they work
The waiters thus realize
We alrea dy refer red to one way. of deal1. . · hard, so they will work hard
~g with agen cy prob lems - (pro babl y-the re is a dang er that it's a priso
ner's dilemma, but we can
thou gh pro babl y the }east inter .
esun g solu uon, and the one that postp one that idea unúl the next chapter).
the least to law: mon itori ng, e1th er by watc . owes
won 't get paid, that's bette r than shirking,
Although sometimes they
h1.ng the agem or inspecting in which case business is al-
.
bis res ul ts. lf the agen t's effo rt can be. mom . tore d perfectly, of cou ways bad and they neve r get paid. But most
people won't accept a con-
. 't an agen cy prob lem; the pnnc 1pal . rse,
there 1sn JUSt pays for what he sees tract like this because they don' t want to risk
, going home with no money
e · · al . on any parú cular day, especially when the
But wh en the m onit orin g can t be per1 .
ect, pnnc 1p s sometimes go to
· bad day might not be their
ch wha t they . fault. Inde ed, most peop le would prefe r a flat
leng ths to wat can. They hire sp1es to pose as co-workers, or salary so that they go home
. the num ber of keys tro k es their . .
secre tane s m ake, or they
with the same amo unt each day no matt er what.
But the owner won't do
they mon itor this beca use the flat salary does n't give the waite
. the back of their truck s te mg o er . 11· th d r a strong enou gh incen-
P ut suck. ers on
if th truck is driv en badly . At a h1gh •
nver s to call and
th · úve to work hard .
com plam e er level ey might try to It's a conu ndru m; but it largely gets solved by
, eting s and • ·
delib erau ons mor e vis1 e, or "transpar- 'bl that excellent economic
mak e the agen ts me inno vaúo n know n as the tip. Thin k of it nota
. s a favor from the customer
ent" They have stu d en ts writ e eval uatio ns of their profe ssors and sub1D1.t to the waiter, or as a way for the owner of
the restaurant to push the
them to the dean . cost of payiñg his ~taff onto bis customers (whe
. . tions to agen cy prob lems mvo • 1 re it always will lie in the
Toe more mter esun g so1u , .
ve contracts end anyway). Thin k ofita s a soluú on toan
agency problem. The owner
. . t take the prin cipa . 1
th at give. the agen t an mce nuve o l s mter ests senous y. wants the waiters to work hard but usually
. . can't observe their dealings
There is • ecum ng tens1. on m . the desi gn of thes e contr acts. The pnn- with their custo mers , so in effect he lets the
customers, who know best,
ar . , a to the resu lts he prod uces , thus givmg .. set a large share of the waiter's salary. Of cours
cipal want s to ue the agen t s P Y e the waiter does n't want
ld rath er be paid regard- his salary to depe nd entirely on tips, because
him a big incen tive to work hard . The ~gen the restaurant migh t have
t wfou king more money if he slow nigh ts that aren 't his fault. So he gets a
less of resul t. True , h e m1g · ht like the idea o ma small guar antee d salary, too:
. 1b de nerv ous by a contract the insur ance side of the arran geme nt. In
rodu ces a lot, but a typic al agen t wil _ effect the waiter's contract
P e mal H will be nervous be- gives him a large r paym ent when business is
in whic h his pay depe nds enur . 1 n h1s resu ts. e good anda smaller payment
eyo d ce good outcomes. if business is bad. This gives waiters an incen
caus e he know s that hard work does n 't úve to work hard but also
alwa ys pro. u the prob lem would prote cts them again st bad luck, as when busin
ess is bad because of bad
(lf there were a perf ect matc h betw een them , agai n. ht prod uce disap- weat her or a bad chef.
. di 1 )
dissolve: he wou ld just be paid acco r ng Y· He m1gr bad luck. He wi•u The cont ract is a comp romi se betw een the
interests of the owner and
ople 's effor ts, 0 the waiter. It man ages to align their inter
Pointi ng resul ts beca use o f o ther pe guar ante e d m0 ney. ests- most ly. But there are a
want insu ranc e agai nst thos e poss1'bT · sorn e
1 iue s-th . <leal smaller; an d the
coup le of wrin kles to notic e. First, as often
happ ens in arrangements to
The princ ipal wil1 pref er to keep that part solve agen cy prob lems , the incentives creat
.º f . : rwill be incli ned to paY ed by this device aren 't quite
large r it gets, the smal ler the bonu s tbe
pnn cip
 cooPERATI0N , AND OTHER PR0BLEM:s
II TRUST ,
O p,1.RT ·
9 ·mes can please the customer at the 0 ......... ,
Waiters someu d d . ks .. "er s ex Chapur 9. AgfflCJ 91
erfect. . e away free foo or nn and are tipped
P hen they giv . • d 1 . • same time, officers also get a salary to compensate th h
pense, as w . f mething like th1s kin - b etween the agent ªVIsh1Y of the stock goes down for reasons that aren't the' f:em w fien the value
J1us1on o so
for it. e0 .
n nagoing problem m agency relationsh i and the a new tax law that eats up the firm's revenues Th
rr au1t- or example
. is a commo
e 1aw also provides
. '
o· . ps. A. re. .
monitor- . th t agents sometimes can fa1l to enforce the pri . ·
oblem is a other help bes1des enforcing the terms of those contra .
nctpal's . cts. 1
late d pr u·ng much visible evidence. A waiter who is rud duues of loyalty on the officers, allows "derivative" lawsui'ts t bet bimposes
. h without crea
wis es people to complain and leave bad tips. A Waitere Will h against them by shareholde rs on behalf of the corporatio n o d rought .
robably cause . . . , an requrres
P thing when he sees the c h e f f:at·¡ to wash his handsw .o that the corporauo n pubhcly d1sclose lots of information abou · lf (
simply does no al'k . Will
• • • ) t 1tse to
d by customer and emp1oyer 1 e. Pass1ve failures of th' make momtonn g eas1er .1 P~oblerns of agency also can puta good face
go undetecte . . al'
. d h as a failure to enforce a pnnc1p s ru1es, can create agen IS on takeovers by corporate raiders. A takeover is tried only if the raiders
~ .-
problems cy think the current managers and directors are failing to get the fullest
that are especially bar~ to solve. (Compar~ police who abuse
cts with lazy police who don t do much of anythmg.) possible value out of the corporatio n. Raiders thus provide a bit more
suspe · 1s· th at · like monitoring ; whatever their unappealin g qualities and the dislocations
Toe other shortcoming of ups waiters, most agents, have they cause, they also help solve agency problems. 2
more than one task the principal wants them to do well, and the incen-
This account of the incentives in a corporatio n is only a small taste ef a
tive to work hard at one of them may come at the expense of the others.
very complex institution al and legal structure. Turn the problem around
Tips might make the waiter eager to help the customers at his own tables
and imagine that an entrepren eur has an idea and wants to raise money
but not very interested in cooperatin g with his colleagues ; thus the time- from investors. The investors are afraid that if they give money to the
honored cry of"not my station" when a waiter is summone d for help by entreprene ur, he will misuse it-perhap s putting sorne of it into the idea,
a diner ata table not his own. One way to relieve the problern is to have but giving the rest of it to himself as a fat salary and perks. They respond
waiters pool their tips. It gives thern reason to be more cooperativ e with to these fears in various ways. Sorne investors will give money to the en-
each other and also provides sorne insurance against the chance that trepreneu r only if he gives them the right to vote on sorne manageme nt
1 one unlucky waiter will draw ali the stingy tippers on a given night. But
notice that pooling takes away sorne of the waiters' incentive to ardently
decisions. Those investors are called shareholde rs. The shareholders
might also demand that a board of directors be created; the directors
serve the customers at their assigned tables, since now they feel ali the monitor the entrepren eur and may have the right to replace him with
costs of working hard but only sorne of the benefits. This time maybe someone else if he makes bad decisions. The directors, of course, might
the owner can relieve the problern by studying credit-car d receipts to see shirk as well, so as suggested above they may be given stock options to
how much each waiter was tipped, and then rewarding the good ones in ensure that they monitor the officers rather than sleep on the job. Mean-
other ways. The details of this story aren 't important ; the point is just to while sorne other investors will lend rnoney to the entreprene ur without
~bserv~ the back-and-forth measures that may be used to cornpensa te for demandin g any control but will charge an interest rate that reflects their
mcenttv«:5 that are helpful in one way but not another. view of these agency problems. Or perhaps this group of investors will
Here 15 another example. The officers of a corporati on are supposed lend rnoney only to huy things that they can recover if they don't get
to serve tbe interests of the sharehold ers but the sharehold ers generally repaid prornptly. These lenders, in either event, are called creditors. The
can't h ' law gives the creditors this additional advantage as well: if the company
see . ow carefully the officers do their jobs. The sharehold ers do~ 't
want to give th Offi goes under, they get repaid before the shareholde rs do. Directors, credi-
e cers a flat salary because then the officers, l'k 1 e wait·
ers on flat salarie d , tors, sharehold ers, and others also might make the entreprene ur hire an
s0 h .
s, on t have a strong enough incenuve to work hard,
outside auditor to review his finances, with the understand ing that the
s areholders oi th ffi
val f º.ve e O cers bonuses at the end of the year wben the ~uditor will be independ ent and have a reputation for making impartial
ue O the stock g hat the
bonuses should be :es up. And rather than trying to figure out wocks or Judgments .
stock option h ach year, the sharehold ers give the officers st fhis Or think of real estate agents. How hard will your agent work to sell
s w ose value
directly ties the offi , goes up when the value of the fi rrn does · t the your house? More .to the point, how will you know? You probably won't;
cer 5 compensat ion to the firm's performan ce. A
 ooPERA TI ON ' AND OTHER PROBL" '"s
.. ..,
ll TRUST, C
911 pART . • 11 for a long time, the agent will be abl
doesn t se th" Chapter 9. Agmry 9!1
ifthe house tions that have no mg to do with hoe to h •
of,
for "ble exp1ana . , . w aro. insuranc e against the results. The temptatio n to misbehav e-the moral
t'. lots ofplaus1 al lution is to al1gn the se1ler s mterests With hazard, the agency cost-wo uld be too great.
1er So the usu so th the
worked.
he · the agen t a commiss ion on .e sale of the house . "rt. .. ne
agent's by paying bta1"ns for it, the greater h1s pay. When we look fi
rice he o
t in this parucula r sort o f contract , though or
•
higher the P
cornpanen d , We
an insurance The agent sees no guarante e money if the hoUs In a moment we will look at sorne more examples, but first let's reflect
't find one. h
usually ond be the reason is that most ouses do sell eventuan e on the practical importan ce these issues can have. As you go through
doesn'tsell atal!. May t also has a different kind ofinsura nce: he worksy, life you are both a principal and an agent ali the time. You are an ordi-
. that the agen .
but nouce . erent principals (i.e., sellers), so even if one house won't nary consume r in the world: in a principal 's relationsh ip to restaurants,
for a lot of difli .d when the others do. cab drivers, real estate agents, people you hire to do work at your house,
sell, he'll g~t pai ·nsurance company and your landlord , ifyou have and so forth. You are in an agent's relationsh ip to all sorts of other par-
Or cons1der your 1 ties with whom you do business, such as your employer and the land-
ave in common ? You are an agent ..eor b oth of those
What do th ey h lords and insuranc e compani es we talked about a moment ago-and ,
one.. hat surprisingly, since you are the one paymg ·
money to
P arues-SOIO eW . . al B ali th again, in other respects you also have a principal 's relationsh ip to them.
. ak you feel like a pnnc1p . ut rec at an agent is
them wh1ch m es You are a principal because you want them to work hard on your behalf.
' . erson whose actions benefit (or harm) someone else¡' You are an agent because they want you to be careful on their behalf.
generally,JUSt a p -ª
rd and insurance company bo th are éUJ.ected
and your 1andl
careful you are.
° Th e landlord wants you to be care f u 1wi"th th
e
by how
apartmen t
So you should think about the contracts you have with all these peo-
ple-abo ut monitori ng, and about trade-offs between incentives and
• and the insurer wants you to be careful with the car
.
insurance .
you are renung,d by your policy But neither can directly see how care- Ifyou happen to be a lawyer, all this becomes especially importan tin
or house covere · . •
Th deal with this through contract ual devices that bear a two ways. The first is that your clients will themselves be agents and prin-
ful you are. ey
f: il resemblance to each other: the security deposit demand ed by the cipals many times over. They may not always be conscious of those roles,
1:dl~rd and the deductible in the insuranc e policy. In ~oth cases the ar perceive their implicati ons, ar know the classic strategies far dealing
principal bears most of the responsib ility for things that rmght go wrong with them. Understa nding those things is your job. And then lawyers
(a kind of insurance far the agent-li terally in the one case and effec- themselves usually stand in complica ted webs of agency relationships. If
tivelyin theother). Butin both ofthem you, as the agent, have to pa~for you are a lawyer you have an agent's relationsh ip to your client, and to
the first chunk of damage, subject to whateve r excuses are wnt · te~ mto your firm, and to the courts in which you practice. They all want you to
.
. .
the contracts. This gives you somethm g to worry a ou · b t Y,ou aren tJUSt work hard and carefully but may find it hard to tell whether that is hap-
pening, and perhaps hard to reassure themselves about it-especi ally
playingwith someone else's money. . when the best thing for one of those principal s isn't the best thing far
An agent's temptation to shirk or misbehav e, espec1'allY m . the msur·
• has 1ts . own name: the others. Meanwhi le you will have a principal 's relationsh ip to other
anee setung, moral hazard . If you have insurance . es parties: to lawyers working with you ar under you, to people you hire to
against a bad thing, your incentive to avoid it goes down. Some~ 't
help with your cases, or-in a less literal but still real sense-to the judge
that's tolerable, as when you have plenty of other incentive s to ,avoi. 1
who presides over your case. It will be importan t to you that they ali work
anyway (life insurance is a good exampl e-so long as you aren t ~
hard and carefully, but this time you may have trouble knowing whether
to take out a policy on the life of a stranger ). But the problem of roo
hazard h J they do or improvin g the odds of it
e ps explain why you will find it hard to buy insurance to cover ..
an ·· . Start with the simple question of how, and how much, a lawyer gets
Y puruuve damages that ever may be awarded agamst . Pun1nve
you.
damages
. . most typi·canY are given . when a defenda nt h as committed an paid when the client wants to bring a lawsuit First notice the agency
mtenttonal b d problem. The client wants the lawyer to work hard but is in a ba~ ~o-
ª act, and we don't want you thmking . . th t you can go
around comm· · . ª h ve sition to tell if that is happenin g. In this respect the lawyer's pos1t1on
itung mtention al bad acts without fear because you a