This problem has been studied extensively by economists within the field of organizational economics, and is called the principal-agent problem (Jensen and Meckling, 1976). In a principal-agent problem a principal (e.g. firm) hires an agent to perform some task. Both the principal and the agent are assumed to be rational expected utility maximisers, but the utility function of the agent and that of the principal are not necessarily aligned, and there is an asymmetry in the information available to each party. This situation can lead the agent into taking actions that are not in the principal’s interests.
As the OP suggests, incentive schemes, such as performance-conditional payments, can be used to bring the interests of the principal and the agent into alignment, as can reducing information asymmetry by introducing regulations enforcing transparency.
The principal-agent problem has also been discussed in the context of AI alignment. I have recently written a working-paper on principal-agent problems that occur with AI agents instantiated using large-language models; see arXiv:2307.11137.
References
Jensen and W. H. Meckling, “Theory of the firm: Managerial behavior, agency costs and ownership structure,” Journal of Financial Economics 3 no. 4, (1976) 305–360
S. Phelps and R. Ranson, “Of Models and Tin Men—a behavioural economics study of principal-agent problems in AI alignment using large-language models”, arXiv:2307.11137, 2023.
That makes sense. I was trying to point at something more specific than the principal-agent problem though. Ie. I agree that it fits under the umbrella of principal-agent problem, but it feels to me like it’s a specific type of principal-agent problem. I’m not sure how to describe it well though. Something about large organizations with an emphasis on large businesses.
Perhaps ‘The Theory of the Firm’? The very existence of large companies is a puzzle if you are a naive believer in the power of free markets, because if the market is efficient then individuals can simply contract with other individuals through the market to achieve their desired inputs and outputs and there is no economic advantage to amassing individuals into higher-level entities called companies. The reason this doesn’t this work is because of transaction costs. An example transaction cost could be the time invested in finding partners to make contracts with for all your inputs and then forming and enforcing contracts. In the ‘the theory of firm’ the insight is that individuals can lower their transaction costs by forming a higher-level economic agent- ie by becoming employees at a larger company. Transaction costs explain why large firms exist, though they don’t eliminate principal-agent problems and may exacerbate them.
As an aside, similar considerations of transaction costs may explain the evolution of multi-cellular life. In evolutionary biology lower level competing units of selection cooperate together to form higher-level entities- genes/genomes, cells/organisms, organisms/groups, groups/societies, resulting in major transitions in evolution. The endosymbiosis between bacteria that led to the evolution of Eukaryotic Cells can be thought of as analogous to forming a company in order to reduce transaction costs. This is discussed further in S. Phelps and Y. I. Russell. Economic drivers of biological complexity. Adaptive Behavior, 23(5):315-326, 2015. [PDF]
Hm. Interesting. I’m confused though. If there were no companies and it was just individuals contracting with one another, I feel like the big issue would be that one person can only do so much. You can’t build cars or apartment buildings with one person. Transaction costs seem trivial in comparison to that.
The point is that all the people making cars in the company could, in principle, do the same job as self employed freelance contractors rather than as employees. Instead of a company you have lots of contracts between eg assembly line workers, salespeople and end customers, without any companies. The same number of cars could in theory be built by the same number of people in each case. The physical scenario would be identical in each case. The machinery would be identical in each case. But in the freelancer case you still have lots of people building cars but there is no invisible company to coordinate this activity instead you are relying the market.
The main problems are the number of contracts and the relationship management problem. Once upon a time drawing up and enforcing the required number of contracts would have been prohibitevly expensive in terms of fees for lawyers. In the modern era Web 3.0 promised smart contracts to solve this kind of problem. But smart contracts don’t solve the problem of incomplete contracts https://en.m.wikipedia.org/wiki/Incomplete_contracts, and this in itself can be seen as a transaction cost in the form of a risk premium. and so we are stuck with companies. In the theory of the firm companies are indeed a bit like socialist enclaves. Individuals give up some of their autonomy and agree not to compete with fellow employees in order to reduce their transaction costs. As you point out the flip side of this is that it can create new principal agent problems, but these are rarely insurmountable. The principal agent problems that we should really worry about are the ones that occur between companies, particularly in financial services. It was a principal agent conflict between rating agencies and investment banks that led to the great financial crisis, as dramatised in the film the Big Short.
This problem has been studied extensively by economists within the field of organizational economics, and is called the principal-agent problem (Jensen and Meckling, 1976). In a principal-agent problem a principal (e.g. firm) hires an agent to perform some task. Both the principal and the agent are assumed to be rational expected utility maximisers, but the utility function of the agent and that of the principal are not necessarily aligned, and there is an asymmetry in the information available to each party. This situation can lead the agent into taking actions that are not in the principal’s interests.
As the OP suggests, incentive schemes, such as performance-conditional payments, can be used to bring the interests of the principal and the agent into alignment, as can reducing information asymmetry by introducing regulations enforcing transparency.
The principal-agent problem has also been discussed in the context of AI alignment. I have recently written a working-paper on principal-agent problems that occur with AI agents instantiated using large-language models; see arXiv:2307.11137.
References
Jensen and W. H. Meckling, “Theory of the firm: Managerial behavior, agency costs and ownership
structure,” Journal of Financial Economics 3 no. 4, (1976) 305–360
S. Phelps and R. Ranson, “Of Models and Tin Men—a behavioural economics study of principal-agent problems in AI alignment using large-language models”, arXiv:2307.11137, 2023.
That makes sense. I was trying to point at something more specific than the principal-agent problem though. Ie. I agree that it fits under the umbrella of principal-agent problem, but it feels to me like it’s a specific type of principal-agent problem. I’m not sure how to describe it well though. Something about large organizations with an emphasis on large businesses.
Perhaps ‘The Theory of the Firm’? The very existence of large companies is a puzzle if you are a naive believer in the power of free markets, because if the market is efficient then individuals can simply contract with other individuals through the market to achieve their desired inputs and outputs and there is no economic advantage to amassing individuals into higher-level entities called companies. The reason this doesn’t this work is because of transaction costs. An example transaction cost could be the time invested in finding partners to make contracts with for all your inputs and then forming and enforcing contracts. In the ‘the theory of firm’ the insight is that individuals can lower their transaction costs by forming a higher-level economic agent- ie by becoming employees at a larger company. Transaction costs explain why large firms exist, though they don’t eliminate principal-agent problems and may exacerbate them.
As an aside, similar considerations of transaction costs may explain the evolution of multi-cellular life. In evolutionary biology lower level competing units of selection cooperate together to form higher-level entities- genes/genomes, cells/organisms, organisms/groups, groups/societies, resulting in major transitions in evolution. The endosymbiosis between bacteria that led to the evolution of Eukaryotic Cells can be thought of as analogous to forming a company in order to reduce transaction costs. This is discussed further in S. Phelps and Y. I. Russell. Economic drivers of biological complexity. Adaptive Behavior, 23(5):315-326, 2015. [PDF]
Hm. Interesting. I’m confused though. If there were no companies and it was just individuals contracting with one another, I feel like the big issue would be that one person can only do so much. You can’t build cars or apartment buildings with one person. Transaction costs seem trivial in comparison to that.
The point is that all the people making cars in the company could, in principle, do the same job as self employed freelance contractors rather than as employees. Instead of a company you have lots of contracts between eg assembly line workers, salespeople and end customers, without any companies. The same number of cars could in theory be built by the same number of people in each case. The physical scenario would be identical in each case. The machinery would be identical in each case. But in the freelancer case you still have lots of people building cars but there is no invisible company to coordinate this activity instead you are relying the market.
Oh yeah, I see. Very interesting. Do any other transaction costs come to mind?
The main problems are the number of contracts and the relationship management problem. Once upon a time drawing up and enforcing the required number of contracts would have been prohibitevly expensive in terms of fees for lawyers. In the modern era Web 3.0 promised smart contracts to solve this kind of problem. But smart contracts don’t solve the problem of incomplete contracts https://en.m.wikipedia.org/wiki/Incomplete_contracts, and this in itself can be seen as a transaction cost in the form of a risk premium. and so we are stuck with companies. In the theory of the firm companies are indeed a bit like socialist enclaves. Individuals give up some of their autonomy and agree not to compete with fellow employees in order to reduce their transaction costs. As you point out the flip side of this is that it can create new principal agent problems, but these are rarely insurmountable. The principal agent problems that we should really worry about are the ones that occur between companies, particularly in financial services. It was a principal agent conflict between rating agencies and investment banks that led to the great financial crisis, as dramatised in the film the Big Short.