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The agency problem

01 February 2008 Robert W Vivian, University of the Witwatersrand

If I were asked the question, 'What is the world's most pervasive economic problem ?', I would give an answer of which very few have heard. In economic theory it is called 'The agency problem' or more fully the 'Principal-agent problem'. It has a number of other manifestations including, among others, moral hazard, adverse selection and conflict of interest.

In a sense, it is a problem which should never have arisen. The opening three chapters of Adam Smith's famous Wealth of Nations are devoted to praising the theory of the division of labour. He explains how much more efficient an economy becomes if it is divided into specialised fields. Indeed, the modern economy is the fulfillment of Adam Smith's division of labour theory. In the ancient agricultural society, the average person never made use of the services of anyone else. In the modern society, we are constantly making use of the services of others. It is this which has allowed the modern complex society to develop into its current fascinating state.

Economy of specialists

If you purchase a motorcar, for example, the providers of the car spend all their time looking at ways of producing better and more efficient cars. In assembling cars, the manufacturer will install thousands of parts. Behind the manufacturers of each of these parts, there are thousands of people who devote their entire life to understanding, making and improving just that one part. And so, in this way, millions of people around the world are devoting their lives to produce simply one evolving item - the car. This can be repeated in every other product and service of the modern world. And, as Adam Smith predicted, the division of labour has produced our wonderful brave new world as each of us do less and less for ourselves and rely more and more on others to do all those things which impact on every aspect of our lives.

The dark side

The division of labour, however, has a dark side, which is called the agency problem. Economically speaking, the person who appoints someone else is the principal and the person doing the work for the other is the agent. The dark side is that the agent may well be doing everything for him- or herself and not the principal. Indeed, increasingly it is almost certain that the agent will be putting his interests before that of the principal.

Across industries

As I have thought of this problem, the extent thereof has become increasingly apparent. A number of years ago, for example, I read of a strange case of a South African undertaker. Now, one would think that there can be no agency problem where undertakers are concerned; the undertaker's clients are, after all, dead. Not so. I discovered that the agency problem does exist, even for undertakers. In this particular case, business was slow, so the undertaker hired a hit-man to murder some of his friends, so that his business would improve. On their demise he was appointed to bury them! I discovered that the agency problem exists in every walk of life.

Take another example. You go to a lawyer with a problem and the lawyer recommends litigation. Is this because you have a case or the lawyer wants to generate fees ?. In the days of Charles Dickens, cases were known to run for over a century due largely to the fact that these generated a never-ending stream of fees. Once, when I went to the local magistrates' court, I noted a lawyer at work. He approached unrepresented clients who were facing criminal charges. For a fee of R1 500, he offered to represent them. On receipt of the fee, he disappeared to see the public prosecutor, returned and advised the client that having spoken to the prosecutor he has concluded that the client has no case and should plead guilty. He then moved on to the next R1 500. I did not see him defend a single client.

In the financial services industry

The financial services in particular fall victim to the principal agent problem. Companies are supposed to maximise the wealth of their shareholders - these today are largely pensioners contributing to pension funds which invest in companies via institutions. The pensioners, the ultimate owners of the capital, are in terms of economic theory the principals and the directors and managers of companies are in reality the agents. These principals have virtually no say. The greatest beneficiaries of the retirement fund system are not the principals but the agents.

Within the traditional activities of intermediaries the existence of the problem is obvious. A member of the public (principal) approaches a financial advisor (agent) for advice. The advisor, however, recommends not the best-suited product, but the product which produces the greatest commission (or fee).

The subprime crisis the world is facing may be yet another example. Agents sold mortgages to people who could not afford them because the agent received commissions on all mortgages sold.

Double agency

The financial industry has a particular problem - a person could be the agent for two parties at the same time. This problem has been highlighted by the courts on a number of occasions when dealing with Lloyd's. An insured (principal) appoints his broker (agent) to deal with a claim. The broker, acting on behalf of his principal, reports the claim to Lloyd's. Lloyd's (principal) then appoints the broker (agent) to appoint a loss adjuster to investigate the claim. The loss adjuster, once finished, gives the report to the broker. The broker now finds that he is the agent for both the insured and insurer at the same time for the same transaction! The courts were not impressed.

I could provide many more practical examples of the agency problem in operation, but I am sure these few are sufficient to draw attention to this pervasive problem. In the modern society, more often than not, when you appoint someone else in a financial transaction, you will find that that person will be trading on his or her own account, not yours, but with your money.

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