Wednesday, January 27, 2010

Naked Economics: Aligning Incentives and Principal-Agent Problem


I'm currently reading Charles Wheelan's Naked Economics. Lawffice Space regulars may recall a series of posts on SuperFreakonomics and its employment law lessons. Tonight, I begin a series of similar posts based on Naked Economics.

The first lesson I will cover from this book is a management classic: the principal-agent problem. The classic example involves a retailer who hires a cashier, or a floor clerk for a set wage, say $8/hour. The employee gets $8/hour no matter how well the business does and therefore has no incentive to make the business succeed. Sure, he'll do just enough to avoid getting fired and maybe even enough to keep the store from going out of business. Obviously, this is still a problem. The store-owner and the employee's incentives do not align.

This problem goes well beyond the store clerk, all the way on up to CEOs of corporations. As Wheelan notes on page 32:
"A study conducted by the consulting firm McKinsey & Company found that something as simple as having a company's directors hold large investments in the company's stock correlates with significantly better company performance."
Why is that? Simple. The incentives are now aligned. The employee has an ownership interest in the business and therefore a financial incentive to see the business succeed.

Of course, stock options for store clerks at small businesses may not be an option. Often, businesses turn instead to a commission model. That should align incentives, right? Well, sort of. Wheelan goes on to explain:
"Your [real estate] agent can list your house for $280,000 and sell it in about twenty minutes. Or she could list it for $320,000 and wait for a buyer who really loves the place. The benefit to you of pricing the house high is huge: $40,000.... Assuming a three percent commission, your agent can make $8,400 for doing virtually nothing or $9,600 for doing many weeks of work."
Wheelan then rhetorically asks, "Which would you choose?" Indeed, partial ownership can only partially align the incentives. Only 100% ownership fully solves the problem. At that point, however, you have no principal-agent problem only because you no longer have any agent at all, it's all principal.

More Naked Economics fun to come!