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July 19, 2018 

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SAVING: The after-tax disposable income of the household sector that is not used for consumption expenditures. In general terms, saving is the use of income to purchase legal claims through financial markets rather than the direct purchase of physical goods and services. In the macroeconomic world modeled by the circular flow, saving is the diversion of household income away from consumption and into the financial markets. In this model, saving is a primary source of funds used for business investment expenditures for capital goods. Saving is also used to finance government expenditures.

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PRINCIPAL-AGENT PROBLEM:

A disconnection or conflict between the objectives and goals of the principal and those of the agent authorized to represent the principal. The principal-agent problem arises because an agent is given the responsibility and authority to take actions that affect both the principal, but can also affect the agent. This problem is common in corporate management, where the principal is shareholders and the agent is managers. It is also common in government, where the principal is the public and the agent is elected leaders.
The principal-agent problem occurs when one person (the principal) authorizes another person (the agent) to act on their behalf. But the agent then undertakes actions that are not necessarily in the best interests of the principal, but are in the best interests of the agent. In particular, the agent might pursue the satisfaction of personal utility, which conflicts with the maximization of utility of the principal.

To illustrate, consider the actions of Logan LaLandon, Vice Mayor of Shady Valley. The primary duty of the Vice Mayor is to act as Chairman of the Committee for the Historical Preservation of Footwear, which oversees the operations of the Shady Valley Shoe Museum. In the context of this present discussion, Logan LaLandon is the agent authorized to represent the citizens of Shady Valley when it comes to the Shady Valley Shoe Museum.

As Chairman of the Shoe Museum Committee, Logan, might be inclined to use a portion of the tax-funded budget to create a special, gated, parking space reserved just for him right next to the Shoe Museum front door. This parking space, while making his life easier on those rare occasions that he actually visits the museum (once in a blue moon), it does little or nothing for the museum other than wasting tax dollars and preventing other expenditures.

If he happens to authorize this parking space, and I'm not saying that he would (or did), then he would be abusing the authority given to him as Chairman of the Shoe Museum Committee (the agent) by the good people of Shady Valley (the principal).

Maximizing Utility

The key to the principal-agent problem is that principals and agents are people, people who seek to maximize utility. As people, they prefer more to less. To satisfy unlimited wants and needs these people take actions and make decisions that generate as much utility as possible. The more, the better. The most, the best. This is the idea of utility maximization.

While the principals authorize the agents to do things that will maximize the utility of the principals, the agents are also people who seek to maximize their own utility. Given the choice between using Shady Valley tax dollars to improve the Shoe Museum (which benefits the principals, Shady Valley citizens) or reducing the distance he walks from parking space to museum front door (which benefits the agent, Logan LaLandon), the Vice Mayor triggers the principal-agent problem when he opts for the parking space.

Good for him, bad for Shady Valley. More utility for Logan, less utility for Shady Valley citizens.

Government Inefficiency

The study of public choice reveals that this disconnection between a principal and a designated agent is a one source of government inefficiency. The principal in this case is society and the agent is a political leader. The principal-agent problem arises because political leaders are prone to maximize their own personal utility rather than doing what might be best for society.

When political leaders fall victim to the principal-agent problem, an inefficient allocation of resources is bound to arise. Rather than making allocation decisions based on the amount of satisfaction generated for all of society (the principal), a political leader might allocate resources based on the satisfaction of only the political leader (the agent). As such, generating the greatest level of satisfaction from available resources, the criterion for efficiency, is difficult if not impossible.

Beyond Government

The principal-agent problem is one source of public sector inefficiency. However, the public sector is not the only example. Consider a few others:
  • Corporate Management: One noted example is the management of corporations. The principal in this case is the corporate stockholder and the agent is the manager or executive hired to run the corporation. The principal-agent problem arises as the manager seeks to maximize personal utility through unneeded company expenditures on travel (company jet), fringe benefits (country club membership), or working environment (rare imported teak wood office furniture) at the expense of corporate profits.

  • Health Care Services: Another common example is provided by medical services. The principal in this case is the patient and the agent is the doctor who is paid to provide medical services. The principal-agent problem arises as the doctor seeks to maximize personal utility and a higher income through unneeded operations or diagnostic tests at the expense of the patients bank account.

  • Higher Education Instruction: A third example is provided by higher education. The principal in this case is the student and the agent is the instructor paid to provide education. The principal-agent problem arises as the instructor structures the course and selects textbooks or other instructional materials to maximize personal utility by reducing work effort at the expense of the student's education.

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Recommended Citation:

PRINCIPAL-AGENT PROBLEM, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: July 19, 2018].


Check Out These Related Terms...

     | public choice | government failures | voting rules | rational ignorance | rational abstention | political entrepreneurs | voting problems | special interest groups | government bureaucracies |


Or For A Little Background...

     | market failures | government functions | public finance | efficiency | public sector | private sector | utility maximization | market efficiency | fifth rule of imperfection | seven economic rules | corporation |


And For Further Study...

     | median voter principle | logrolling | voting paradox | capture theory of regulation | rent seeking | Tiebout hypothesis |


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