There
are a very few broad concepts that economists have identified as being problems
that are quite difficult to solve. They go
by dramatic and ominous names like “adverse selection”, “moral hazard”, and most
difficultly, “tragedy of the commons”. One
such problem that I’ve encountered recently is the principal-agent problem, the
idea that non-optimal outcomes will result when the person acting is different
than the one who will take the consequences of the action.
In economics,
we often solve problems by creating incentive structures that will make it in
the best interest of a person to alter his behavior. Too much pollution? Carbon tax. This makes it more costly to pollute (the new
incentive structure) and so incents companies to find greener practices (the
altered behavior) that are cheaper than paying the tax. These kinds of schemes work in the business
world too as we see compensation tied to performance. If a salesman doesn’t sell, he makes very
little money, and vice versa, thus incenting hard work. These solutions work because people are
self-interested and will do what is best for themselves. Ideally, incentive schemes are constructed in
such a way that those self-interests are aligned with socially beneficial ones
as well, lower pollution and more sales for the company in the former cases.
A problem,
which we say is the “Principal-Agent Problem”, arises when the consequences of
actions are divorced from the ones doing them.
While the name may conjure up an image of school headmasters conferring
with CIA members, we use these words in a different sense. So what are
principals and agents? A principal is one
who enlists the services of an agent to act on his behalf. So by extension, an agent is one who acts on
behalf of a principal. People buying and
selling houses are principals and the ones who broker the transactions are
called “real estate agents”. Take this following story as an example. One of my friends works in the Air Force as a
bomb technician and he said that the screws that they use on a particular bomb
cost over 100 dollars each and that the only way that they are different than
the screws at Home Depot, besides the fact that they only cost 10 cents there,
is that they are stamped with a serial number.
The problem arises when
there is a mismatch between the consequences of the principal (the general
public who enlists and funds the defense services of the military by paying taxes)
and the agent (the military, which can use all the money its collective heart
desires without any regard to future stability or practicality of its methods).
The military can spend indiscriminately
because it knows that the tax payers will always be around to foot the bill and
so they have no incentive to change their ways. Tax payers end up buying screws for a thousand
times as much than if they were a private contractors getting those screws from
a hardware store. See the problem? Luckily the government doesn’t yet have
monopolies in too many industries besides defense (for good reason, I suppose)
and free market competition is allowed to prevail. The average contractor will get his screws at
Home Depot because the cheaper he can get them, the cheaper he can pass his
services on to customers. There is no
principal-agent problem here because the contractor’s actions affect him only. The same applies to practitioners in other
industries as well.
But I ask you this,
that as we come to a time of eventual governmental dominance of the health care
system, what new principal-agent problems will be created? If divorced incentives allow an entity to
thrive even when it spends a thousand times as much as it could on a screw,
what does that tell you about the people, incentive structures, practices, policies,
etc. of the rest of that entity? You
must extrapolate because I don’t have the words to express it all. In light of this, imagine that we’re talking about peoples’
lives and not metal fasteners: who’s screwed then?
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