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Principal-Agent Models

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Encyclopedia of Complexity and Systems Science

Definition of the Subject

Principal-Agent models provide the theory of contracts underasymmetric information. Such a theory analyzes the characteristics of optimalcontracts and the variables that influence these characteristics, according to the behaviorand information of the parties to the contract. This approach has a close relation to game theory and mechanismdesign : it analyzes the strategic behavior by agents who hold private informationand proposes mechanisms that minimize the inefficiencies due to such strategic behavior. Thecosts incurred by the principal (the contractor) to ensure that the agents (the contractees)will act in her interest are some type of transactioncost . These costs include the tasks of investigating and selecting appropriateagents, gaining information to set performance standards, monitoring agents, bonding paymentsby the agents, and residual losses.

Principal-agent theory (and Information Economicsingeneral) is possibly the area of economics that has...

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Abbreviations

Information economics :

Information economics studies how information and its distributions among the players affect economic decisions.

Asymmetric information :

In a relationship or a transaction, there is asymmetric information when one party has more or better information than other party concerning relevant characteristics of the relationship or the transaction. There are two types of asymmetric information problems: Moral Hazard and Adverse Selection.

Principal–agent :

The principal-agent model identifies the difficulties that arise in situations where there is asymmetric information between two parties and finds the best contract in such environments. The “principal” is the name used for the contractor while the “agent” corresponds to the contractee. Both principal and agent could be individuals, institutions, organizations, or decision centers. The optimal solutions propose mechanisms that try to align the interests of the agent with those of the principal, such as piece rates or profit sharing; or that induce the agent to reveal the information, such as self‐reporting contracts.

Moral hazard (hidden action):

The term moral hazard initially referred to the possibility that the redistribution of risk (such as insurance which transfers risk from the insured to the insurer) changes people's behavior. This term, which has been used in the insurance industry for many years, was studied first by Kenneth Arrow.

In principal-agent models, the term moral hazard is used to refer to all environments where the ignorant party lacks information about the behavior of the other party once the agreement has been signed, in such a way that the asymmetry arises after the contract is settled.

Adverse selection (hidden information):

The term adverse selection was originally used in insurance. It describes a situation where, as a result of private information, the insured are more likely to suffer a loss than the uninsured (such as offering a life insurance contract at a given premium may imply that only the people with a risk of dying over the average take it).

In principal-agent models, we say that there is an adverse selection problem when the ignorant party lacks information while negotiating a contract, in such a way that the asymmetry is previous to the relationship.

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Authors and Affiliations

  1. Universitat Autònoma de Barcelona, Barcelona, Spain

    Inés Macho-Stadler & David Pérez-Castrillo

Authors
  1. Inés Macho-Stadler
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Editors and Affiliations

  1. RAMTECH LIMITED, 122 Escalle Lane, Larkspur, CA, 94939, USA

    Robert A. Meyers Ph. D. (Editor-in-Chief) (Editor-in-Chief)

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Macho-Stadler, I., Pérez-Castrillo, D. (2009). Principal-Agent Models. In: Meyers, R. (eds) Encyclopedia of Complexity and Systems Science. Springer, New York, NY. https://doi.org/10.1007/978-0-387-30440-3_416

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