Abstract
In this essay I focus on the equilibrium relation between the “risk” in a performance measure and the “strength” of the controlling agent’s “incentives.” The main motivation is that a large (mainly empirical) literature has developed postulating that the key implication of the principal-agent model is that this relation be negative. I first show that a standard principal-agent model, e.g., Holmström (1979), offers no equilibrium prediction about the relation between “risk” and “incentives.” Next, I show that except in the highly stylized limiting Brownian version of Holmström and Milgrom (1987), this model doesn’t yield a directional prediction for the equilibrium relation between “risk” and “incentives” either. This is due to the general property that risk arises endogenously in such principal-agent models. This, in turn, establishes that while the mixed empirical evidence on this relation may be useful from a descriptive vantage point, it does not shed any light on the validity of the principal-agent theory.
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Hemmer, T. (2007). On The Subtleties of the Principal-Agent Model. In: Antle, R., Gjesdal, F., Liang, P.J. (eds) Essays in Accounting Theory in Honour of Joel S. Demski. Springer, New York, NY. https://doi.org/10.1007/978-0-387-30399-4_6
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DOI: https://doi.org/10.1007/978-0-387-30399-4_6
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