2019-07-15 concepts

Complete contracts, the principal-agent problem, asymmetric information

Hey all -

Today’s newsletter features yet another speculative and provocative theory, this time regarding our work relationships. As usual: sorry, but also, enjoy.

+ mental models #

* Complete contracts

Imagine you hire someone to clean up your house this weekend. You agree to pay them $100, and they agree to clean up your house. There’s explicit agreement by both sides.

Now, in an ideal world, they come over this weekend, clean up your house, and you pay them $100. Simple.

In a less than ideal world, they come over this weekend, clean up your house, but also eat all the food in the fridge.

Problematically, you just sort of assumed they wouldn’t do that. You assumed there was tacit agreement - something which didn’t have to be explicitly agreed upon. You assumed they were coming by to clean up your house, and only to clean up your house, and not to also eat all the food in your fridge.

If you accused them of wrongly eating all the food in your fridge, they could quite rightly respond: “Well you never said I couldn’t do that!”

The problem here is that explicit agreements can never completely capture every possible thing which could happen in the future. We rely on tacit agreement to fill in the gaps of what is explicitly agreed upon. As a result, all agreements and contracts are - in their explicit forms - necessarily incomplete.

So what happens if our assumptions about what is tacitly agreed upon don’t line up perfectly?

Well then there is “room for disagreement.” There’s outstanding ambiguity: things that need to be specified, clarified, made explicit. In short, we need to communicate.

Communication allows us to construct, often in real-time, increasingly complete agreements. Without it, we inevitably run into disagreements over all the implicit assumptions we never explicitly clarified. Unsurprisingly, this does not lead to a very agreeable relationship!

But even if we ever could achieve a theoretically complete agreement, we’ve only won half the battle. The other half is getting the job done - that is, performance of the agreement.

* The principal-agent problem

Imagine again you hire someone to clean up your house this weekend. You - the “principal” - pay someone - the “agent” - to perform a service for you.

You agree to pay them $100, and they agree to clean up your house. There’s explicit agreement by both sides.

Now, in an ideal world, they come over this weekend, clean up your house, and you pay them $100. Simple.

In a less than ideal world, they come over this weekend, but this time only clean up half your house. Problematically, you left $100 on the kitchen counter, which they collect in full anyway.

Here we encounter the principal-agent problem. Namely, the agent did not satisfy their end of the agreement because they had other interests. Maybe they had to leave a bit early, maybe they simply forgot, or maybe they just didn’t feel like it.

This is costly! While $50 went to cleaning your house, the other $50 did not. Instead, it was diverted away to the agent, by the agent, without satisfying the agreed upon service. This diversion of resources - this “slippage” - is what economists call an agency cost.

We might define the agency cost as any deviation from the performance of a theoretically complete contract. If the principal and agent could achieve perfect agreement - both explicitly and implicitly - then any departure from that agreement would represent a cost to the principal.

In many cases, such as in the example above, the cost to the principal becomes a benefit for the agent. After all, the cleaner got an extra $50 for doing nothing! In fact, this benefit which accrues to the agent “for doing nothing” is what economists call an economic rent.

Well, things could be worse. The cleaner could have thrown a party at your house, made a huge mess, and collected the $100 anyway. The cost to clean this all up may be well over $1,000.

Strictly financially speaking, their economic rent was $100 and your agency cost was at least $1,100. Here we can see that your agency cost is not bound by the terms of the agreement. You could be on the hook for much more - a major liability risk!

Obviously, if you’re the principal, you want to minimize this agency cost.

There are several things you could do. You could monitor the cleaner by setting up cameras in your house. You could penalize them for not satisfying their end of the agreement, like by threatening to sue. You could offer them a performance incentive, maybe a $20 tip, just to really make sure they clean up the place and do a good job.

But the main thing you could do is to simply never work with them again. Fool me once, shame on you; fool me twice, shame on me.

You’d stamp out the principal-agent problem the very first time you noticed it! It would never, ever become a chronic issue.

… unless, of course, you didn’t notice it.

* Asymmetric information

Imagine once again you hire someone to clean up your house, except only this time it is your vacation home in a foreign country, and you only visit once a year. You pay the cleaner $100 to clean it once a month.

Now, if the cleaner is both clever and dishonest, they could simply say they cleaned the house without ever actually cleaning the house. They know whether or not they cleaned the house, but you do not, so you just have to take their word for it.

In other words, they have more information than you do. Here, economists would say there is asymmetric information. The amount of information held by each party is not equal - it’s not symmetric.

If you’re the cleaner, this is a great position to be in! You could collect $100 in economic rent just by saying you cleaned the house without actually cleaning it. Or, you could collect $500 in economic rent by saying a mischief of rats made a huge mess, and so the house took way longer to clean than usual. You, the homeowner and principal, reluctantly respond: “I guess I have to take your word for it.”

As the agent, the greater the asymmetric information, the greater the potential for economic rent. So if you’re really bold, you may even try to create information asymmetry. You may reduce the information available to the principal by making it hard to see what’s really going on.

For example, if you’re the cleaner, you may “mistakenly” disconnect the security cameras at the homeowner’s vacation home. If you’re a programmer, you may make the code as complex as possible - a black box so to speak - so that only you possess the knowledge to operate it. If you’re a lawyer, you may utilize as much legal jargon as possible with clients so that they become utterly reliant on you to understand even the very basics of what’s happening. If you’re a tax specialist or a digital marketer or a management consultant…

Well, you get the point. If you’re pretty much any agent, you may do things which make the principal’s visibility just a little bit more opaque, a little more cloudy. After all, the only thing the principal can ever say is: “I guess I have to take your word for it.”

This is fascinating. I often used to think that complexity was a mere byproduct of building things. Now, on the contrary, it may in fact be there by design. If you see a black box, look for the key master.

While agents have an incentive to maximize information asymmetry, principals have an incentive to minimize it. As a result we may expect principals to prefer more documentation, more transparency, more communication and more visibility into the inner workings of things.

And, naturally, we’d expect agents to prefer the exact opposite: information silos, poor communication, spotty documentation and a general reluctance to share knowledge. After all, information asymmetry pays the (economic) rent!

Now before you think I’m starting some class warfare against agents, I will remind you that, to some degree or another, everyone is an agent. We all agree to do things for other people, and we all try to satisfy the performance of those agreements. Whether it’s with friends and family, or with employers and investors, we all play both sides as principal and agent depending on the situation.

+ parting thoughts #

One thing we can gather from all of this is that principal-agent problems are everywhere, and they can be big. The question is not whether or not there will be agency costs, but how much they will be.

Given this, how do we reduce agency costs? I have a few ideas:

(1) We accept the agency cost as simply a “cost of doing business.” We won’t agree on everything, and even if we did, we won’t always disclose when we didn’t do exactly what we agreed to do. That seems like an inevitable fact of life, and one we should probably get over.

(2) We communicate better. More specifically, we make sure that we really clarify - explicitly! - the expectations of the agreement. When agreements fail to capture all of the incentives involved - often because they take advantage of one side or fail to stay current - the agent will try to “make up the difference” by underperforming on their side of the agreement. For example, if an employee really wants to take Fridays off (the incentive), but their employer doesn’t let them (the agreement), the employee will underperform anyway. If both sides come to genuine agreement - take Friday off but make up the hours elsewhere - suddenly the agent has less incentive to underperform. If there’s no deviation from this genuine, theoretically complete agreement, then there’s no agency cost, and no economic rent. Better communication enables better agreements, which capture all the incentives of both sides.

(3) We reduce information asymmetry. While we could penalize complexity - that is, anything that looks like a black box - sometimes complexity is necessary, and we don’t want to discourage or disrupt necessary complexity. A better strategy is probably to reward simplicity and transparency. Give recognition or bonuses to those who engage in knowledge sharing, peer review, public talks and comprehensive documentation. This reduces the agent’s “moat” of knowledge, and now anyone - including the principal - can dig into the mechanics of how things really work.

To summarize, in order to reduce agency costs, we need to reduce ambiguity. Either we reduce the ambiguity around our tacit assumptions, or we reduce the ambiguity around the performance of an agreement.

This tells me that, if you’re a principal, one of your primary jobs is to overcome ambiguity. There are powerful forces out there - namely, incentives! - which want to create ambiguity. And your job is to construct and shape incentives such that you minimize it.

You could do this by encouraging and practicing honesty, communicating better, crafting better agreements, or just being more likable. But one way or another, if you want to make working relationships as productive and agreeable as possible, you need to reduce ambiguity.

Thanks for reading,