Sunday, March 14, 2010

Unit 6 - Asymmetric information and principal agent problems

Unit 6 was looking at different aspects of principal-agent relationships. The unit talks about general problems that can be associated with these relationships, pre-contractual and post contractual opportunism and principal-agent contracts. Also the unit describes an example called sharecopper where risks and rewards are shared between principal and agents.

As a previous consulting engineer, I was involved in many principal-agent games. Sometimes I was an agent to our client who was the principal. We did not purposely try to hold any information from the clients however in many cases due to a lack of knowledge we were not often able to give all information to our client. I.e. there was an asymmetric information situation that aroused. In some instances it could be viewed that the asymmetric information between our client and us was also generated by us. We having more knowledge about certain projects were of benefits to us as well as disadvantages. It was a benefit because it mean that we could charge more to a job because our client needed our expertise for more issues arising with the job. Sometimes our fees could be above the market value because of large switch over costs to other consultants, however on clients which could potentially return with more projects we did not abuse our situation. Having asymmetric information was also a disadvantage because it added more responsibility onto our decisions. If the client is not happy with something after it was built (especially they notice aesthetic things) we were held to blame as the client did not know what was being built, and it was our responsibility to design it the way they wanted. This situation often aroused itself when the client was not happy with the aesthetic of something and we were mainly worried about reducing construction costs as our client may of specified at the start of the project.

We were sometimes the principal for our clients when acting for them to find a contractor (agent). One process when finding a contractor we often used was tender negotiations. This could be viewed as a repeated principal-agent game. We often sent tenders out to many different contractors for construction of new projects. The contractors would make an offer for construction of the project. If the offer was appealing which took in a number of factors such as price, number of subcontractors used, time of construction etc, we would accept. The contractor could then decide if they were to put in a high effort or a low effort, which often resulted in quality and timeless of the job. We often would remember previous experience of a contractor and take into account when deciding on awarding contracts for new projects. I.e. if on another tender the contractor had a low price but we had bad experiences with them and there was another contractor with a slightly higher price but we had better experiences with them, we would often chose the second contractor. As the higher the effort the contractor puts in often saves the client money for many reason such as timeliness, i.e. they could put their developments on the market earlier and start gaining capital and earning interest off that capital.

Often being an engineer we like to make our contracts as explicit as possible, as there can be a lot of public responsibility in constructing a project and also our contractors will also try and find short-cuts and loopholes in a contract to try and save themselves effort and money. However, often the problem was we as engineers were writing up the contract and we tried to think of all the possible outcomes however this is more than often not possible. The principles of law are not a engineers specialties and often no lawyer has looked over the contracts to find loopholes before they are signed. Therefore we cannot find make the contracts work. Secondly, as projects evolve work that was not initially covered in the contract is now required to be done by the contract. Often this work is decided and discussed at site meetings. This would be a implicit kind of contract, we did our best to make it explicit as possible but more often than not it was not the case as to save time and money for both the contractor and client.

Corporate governance is defined by business author Gabrielle O'Donovan as an “internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders, by directing and controlling management activities with good business savvy, objectivity, accountability and integrity. Sound corporate governance is reliant on external marketplace commitment and legislation, plus a healthy board culture which safeguards policies and processes.” [wikipedia,, 14/03/10 9.15pm.

Corporate governance is a principal-agent relationship between shareholders, board of directors, management and other stakeholders. It can be a very effective way of managing particularly large businesses with many shareholders and employees. However it does have its downsides. The above definition says that it services the needs of shareholders and other stakeholders. However, it does not often satisfy all stakeholders many different levels/stakeholders within the organisation have different objectives and there is often an asymmetric information imbalance.

Some shareholders (principal) are worried about short term profit as they see it as a short term investment while board of directors (agent) may be aiming for longevity of the company to ensure the need for their job continues. Also board of directors often hold more information regarding the running of the company compared to the shareholders, it has been known for board of directors not to report information/manipulate information for their own gain like keeping their job if the company has made a net lost.

Asymmetric information is also held between board of directors (principal) and management (agent). For example if a company employees are un-happy with their working conditions and this information is only held by the managers, the managers may not report this to the board of directors because they may loss their managerial position. However, if the employees are unhappy it may lead to for say union action and this could be very costly to the whole company.