A bit on the Principal Agent Problem

Recently, Sambaran Mitra asked:

Why would an honest person run for public office or serve as a committee member of a resident welfare association? What kind of system will provide the right incentives for honest people to assume public office?

Designing proper mechanisms for ensuring honest behavior in officials is well-understood. The general class of problems is known as the “principal agent” problems. 

The politicians are the agents of the citizens who are the principals; the resident welfare association members are the agents of the residents who are the principals. The managers of a firm are the agents and the shareholders of the firm are the principals. The workers are the agents and the owner of the firm is the principal.

Agency Problem

The so-called agency problem is that the agent has an incentive to not work as hard as the principal would like him to. The principal would have to bear the cost of supervising the agent to detect shirking. The store clerk could steal from the cash register by not ringing up a sale. Some oversight would be required to prevent that.

One method to fix the problem of shirking is called “efficiency wages.” Pay higher wages than “market wages” so that the worker has an incentive to avoid getting fired for shirking or bad behavior. That is, make it so that the cost of losing the position is higher than the gains from inappropriate behavior.

Let’s take the easier case of the member of a resident welfare association. The stakes are low. At most a crooked member could get some kickbacks from service providers (maintenance, cleaning, security, etc.) The time and effort to serve as a member on the committee is maybe a few hours per month. Why would an honest person serve? Out of sense of duty toward the community, perhaps. Or perhaps because he feels strongly about some issue. The sort of people who used to write letters to the editors of newspapers.

In the case of politicians, this is a pretty big problem. In most low-income countries, the politicians and bureaucrats are extremely dishonest. The cause and effect are bi-directional — the cause of low income is incompetent and dishonest policymakers, and the cause of incompetent and dishonest policymakers is low income. It’s hard to escape that trap.

Singapore

Singapore is the best example of a country that escaped that trap. It was a low-income country. Lee Kwan Yew, the first prime minister, was an autocrat. He took a zero-toleration policy toward dishonesty and corruption. One time, a minister who was close to LKY was reported to have taken a bribe. LKY had a meeting with him one day and the next day the minister shot himself in his car. The incident was well publicized — the message being that it is very costly to take bribes in Singapore. 

LKY paid his ministers “efficiency wages.” Highly competent people get paid in the millions as CXOs of private sector firms. LKY paid his ministers extremely high salaries — comparable to the compensation of CXOs of large multinational firms.

Compare that to the situation in India. In India, the politicians are paid peanuts. But they have enormous opportunities for collecting bribes amounting to millions of dollars (or hundreds of crores of rupees.) Same for the bureaucrats. They too make millions, especially those in the tax departments. And then there’s the police: even the job of a lowly police officer goes for a very high price. Finally, the judiciary is corrupt. Judges take bribes to not delay cases and take bribes to decide cases. 

The pay is not much at all. The bribes are the reward. Furthermore because the perks of office are so high, the competition is quite cut-throat (literally and figuratively.)

Public Flogging

Some years ago I wrote that one can figure out a system to root out public corruption. My solution involved the liberal use of public flogging. Here’s a bit from a fairly long post from 2005, The Ownership Society

I don’t really care whether the railways are run by the government or not. But if there is a train accident, the rule should be that the railway minister will be flogged publicly and given as many lashes as there are deaths due to that accident.

Public flogging of public officials is the answer to the problem of public officials not taking their charges seriously. Not just corporations. Take politicians. Any election promises they make about how they will change the economy must be taken seriously. And then if they fail to deliver, hold their feet to the fire. Candidate A claims that he will make something happen, then as elected leader A, he becomes the owner of that something. If he does not deliver—you guessed it—public flogging.

Want to be the prime minister of India? No problem. Take ownership of the country and set goals that you say you will achieve. If the goals are not achieved as promised by you, public flogging over an extended period of time. What this will do is to bring the right sort of people into public life. People who know what they are capable of doing and who will not mess with the fate of millions knowing that their behinds —literally— will be on the line.

Flogging is a simple enough measure to implement. It does not require high tech equipment. What it does require is a judiciary that can impose the punishment and carry it out.

Corruption in an organization? Here is my solution which will fix it pretty fast. Suppose Mr A has been involved in corruption. Don’t just flog Mr A, get his boss (Mr B) and his boss’s boss (Mr C) and flog them as well. Why so? Because Mr C will be extra vigilant and keep on Mr B’s case and tell him to be on the lookout that no one under him is into corruption.

What this multi-level flogging does is this. It makes managers liable for corruption in institutions that they control. That is, it give the managers ownership of the organization they control. Irrespective of how deep the organization is, if a person at a certain level is corrupt, include the two higher levels and flog those two individuals as well.

You may think that I am not really serious. But I am. I am dead serious about this. You want to make India the least corrupt economy on earth, get serious about dealing with the problem for just a few years. After a few dozen high level officials have been publicly flogged, corruption will be a thing of the past which children will read about in their history books.

End excerpt. Go read it all.

Related posts: Solution to India’s Greatest Failure. And The Habit of Honesty.

Also read Robert Higgs’ piece Representative Government Suffers from the Principal-Agent Problem.

5 thoughts on “A bit on the Principal Agent Problem

  1. Prabhudesai Monday April 19, 2021 / 5:29 pm

    Here is another question (unrelated to post).

    Is competition always a force for good ?

    Are there any preconditions that we often take for granted. For example, for trade to be a zero sum game always we want both parties to participate voluntarily. But we often omit this important caveat when claiming trade is a good thing.

    There is fierce competition to become an actress in hollywood. Thousands of young girls ruin their lives in the process but only one of them becomes a top famous actress. The acting schools and other industry might be bigger than the collective earning of all top famous actresses.

    As a consumer of movies I can not say I am better off because of this tough competition because I am pretty sure that for every top successful actress there are dozen more who can act better, who are more beautiful but currently working as waitresses at Hooters.

    Or you can take a similar example of JEE. An examination that has too much of competition resulting to very high cost of producing one engineer. For a poor country like India it is a massive blow. Since you have already written about this topic, you know what I mean.

    Like

    • Atanu Dey Monday April 19, 2021 / 5:49 pm

      Prabhudesai, you write, ” For example, for trade to be a zero sum game always we want both parties to participate voluntarily.” Do you mean non-zero sum, and not zero sum?

      Like

      • Prabhudesai Monday April 19, 2021 / 8:40 pm

        It was a mistake. Read it as “for trade to be positive sum game”.

        Like

  2. baransam1 Sunday April 25, 2021 / 2:35 am

    Thanks, Atanu, for taking the time and effort to reply to my query.
    Currently, the official remuneration of the elected representative is peanuts. For Loksabha MP, it is 1lakh+allowances. This salary is too low to be an incentive for a person to choose Loksabha-MP as a career. The only legitimate reason for a person to run for Loksabha is that (s)he is ‘publicly spirited’ and is sufficiently irrigated with ‘milk of human kindness of empathy’. The folks who write letters to the editors (this was a nice phrase that you used) are the only honest people who will run for public office for ethical reasons. Everybody else will have a different reason for vying for public office. Most of those reasons will be dishonourable ones.

    The situation is even worse in Resident Welfare Associations (RWAs). Here there is mainly zero remuneration for holding office. The pain, on the other hand, is too overwhelming for salary-earning-middle-class people. There are always some troublemakers who will file cases against the secretary/president. There are keyboard warriors who continuously foul mouth office bearers on forums.

    Your idea of public flogging is not directly relevant to the problem I cited above. I am referring to the situation where no agents will come forward to serve the principal (as it happens in many RWAs). On election day, people do not show up in meetings, lest the sparse gathering forces them to be the new office bearers. In one of my earlier RWAs, a brave man showed up and willingly accepted to be President. We all looked at him with awe and respected his public-spiritedness. It turned out that he was XXX-Telecom’s sales manager. He promptly turned over the intercom system to XXX-Telecom and pushed XXX-handsets in every flat. After few months, he resigned. In the absence of a good incentive, these are the kinds of people who occupy public offices. Moral-reasons, “urge-to-do-good” kind of reasons are not very strong.

    Like

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