Monday, February 23, 2015

Three tier agency structures

In the simplest principal agent model, there is one principal, one agent, and one dimension of effort. The principal (for example an owner) tries to motivate the agent with monetary (extrinsic) incentives. In the real world, agency relationships can be much more complex than this. For example, in sports, managers and referees are in between higher principals and agents. The higher bodies are club officials, governing bodies and leagues, which define the institutional framework and the incentive structure of managers and referees, and determine the quality of their role as coordinators or rule-enforcers. Academics and teachers have a similar role: they are the principals for students, but they are agents of other principals themselves. Their performance depends on the institutional quality determined by the higher principals: the university or school authorities and rules. Managers, referees and teachers try to combine extrinsic and intrinsic incentives as well as they can. Intrinsic incentives are especially important when there are quality issues or other dimensions that are hard to measure but important nevertheless. Sometimes extrinsic incentives may crowd out intrinsic incentives, like when highly motivated students are asked to waste time answering a formal test. But sometimes extrinsic incentives complement intrinsic incentives, like when a league reforms the incentive system of referees, as it has been happening in European soccer leagues in the recent past. In institutions such as the education system, or even the financial system, where those who are in contact with the customers or users are agents themselves, the quality of these complex contractual structures are a key component of institutional quality. In this case, good institutions are those that give good extrinsic and intrinsic incentives to intermediate agents.

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