The Economic Theory of Agency: The Principal's Problem

The relationship of agency is one of the oldest and commonest codified modes of social interaction. We will say that an agency relationship has arisen between two (or more) parties when one, designated as the agent, acts for, on behalf of, or as representative for the other, designated the principal, in a particular domain of decision problems. Examples of agency are universal. Essentially all contractural arrangements, as between employer and employee or the state and the governed, for example, contain important elements of agency. In addition, without explicitly studying the agency relationship, much of the economic literature on problems of moral hazard (see K. J. Arrow) is concerned with problems raised by agency. In a general equilibrium context the study of information flows (see J. Marschak and R. Radner) or of financial intermediaries in monetary models is also an example of agency theory. The canonical agency problem can be posed as follows. Assume that both the agent and the principal possess state independent von Neumann-Morgenstern utility functions, G(.) and U(.) respectively, and that they act so as to maximize their expected utility. The problems of agency are really most interesting when seen as involving choice under uncertainty and this is the view we will adopt. The agent may choose an act, aCA, a feasible action space, and the random payoff from this act, w(a, 0), will depend on the random state of nature O(EQ the state space set), unknown to the agent when a is chosen. By assumption the agent and the principal have agreed upon a fee schedule f to be paid to the agent for his services. T he fee, f, is generally a function of both the state of the world, 0, and the action, a, but we will assume that the action can influence the parties and, hence, the fee only through its impact on the payoff. T his permits us to write,