Founded in 2016, Ceteris Paribus is A student-led economics and finance publication at Davidson College.

The Principle-Agent Problem

by Caroline Okel

 

The principle-agent problem is what occurs when the incentives of a firm do not line up with the desires of one or more workers in the firm. In general, the goal of a worker is to maximize utility through a bundle of leisure and income, and the goal of a firm is to minimize costs and maximize profits in the long run; principle-agent problems arise when these two goals conflict. In order to examine the effects of principle-agent problems, we can analyze two different scenarios. Firstly, we will look into the life of a custodian working for a public school in an urban area, and secondly, we will examine the life of a legal assistant working for a busy lawyer.

We will begin by analyzing the potential for principle-agent problems for a custodian in a public high school in an urban area. We will be looking specifically into the life of a custodian who depends on his hourly wage as his main source of income. According to the United States Department of Labor’s Bureau of Labor Statistics, the median wage for a janitor in the United States was $11.27 per hour in 2015 and the mean wage was $12.59. However, the mean hourly wage for janitors working in secondary public schools was higher than the general average, at $13.51 per hour, so we will assume that this is the wage of the janitor we are examining. The majority of custodians work full-time, so they receive benefits on top of their hourly wages. Because our janitor works at a school, he will be primarily working during school hours and in the afternoon, so his hours will be more favorable than janitors who work for office buildings and other areas who have to work during the night.

    We can assume that our janitor’s main objective from his job is to increase his utility. If he is making $13.51 per hour and works full-time at 2,080 hours per year, he will be making an annual salary of roughly $28,100 per year. As long as he is a member of a family of five people or less, this wage puts him above the poverty threshold, but this annual salary still would make it difficult to provide for a family. Therefore, our janitor will probably have a higher marginal utility from hours of labor than hours spent on leisure, and he will want to earn as much money as possible to add to his income in order to properly provide for himself and for his family. The incentive of the public school he works for will be to minimize costs so that the majority of funds can be spent on the education of the students in the school, so the school will do whatever it can to minimize the amount of spending.

To make this goal more complicated for public schools, many school districts have faced budget cuts since the recession. Unfortunately, schools in urban areas have been disproportionately affected. These budget cuts have resulted in schools having to reduce spending in order to maximize the funding that goes to the students, and this has lead to changes in spending on cleaning services. Some schools have demoted custodians from being full-time workers to part-time in order to avoid having to pay benefits, and other schools have enforced extremely particular and random schedules for custodial staff in order to avoid having to pay them for any overtime hours. These changes prevent custodial staff from having the ability to maximize their incomes and clearly contrast with the staff’s personal desires, creating a principle-agent problem. A potential solution to the problem regarding full-time workers being demoted to part-time workers to avoid paying benefits could be a contract signed at the beginning of the employment that protects full-time employees from facing this change to becoming part-time. A solution to the problem with cutting overtime hours would be for the school to set a maximum amount of overtime hours allowed for custodians to work per week that works within the school’s new budget. This would allow for opportunities to work overtime even if these overtime hours are limited. These two solutions would both lessen the burden of the principle-agent problem on our custodian if he faced either of these issues.

Another example of the principle-agent problem can be seen through the experiences of a legal assistant working for a busy lawyer. We will look into the life of a legal assistant who conducts research for a lawyer’s upcoming trials, helps this lawyer prepare for trial, and schedules and arranges meetings with clients. Legal assistants generally are paid by the hour, and the mean hourly wage for legal assistants in 2015 was $25.19 per hour and the median wage was $23.47 per hour. (“Occupational Employment and Wages: Paralegals and Legal Assistants,” 2016). The majority of legal assistants are full-time workers, and some legal assistants are expected to work more than the traditional 40 hours per week in order to complete research and meet deadlines (“Paralegals and Legal Assistants,” 2015). By the Fair Labor Standards Act, because legal assistants are paid by the hour, they receive overtime pay whenever they work more than 40 hours. We will assume that our legal assistant makes the median wage of $23.47 per hour and that she is a full-time worker who regularly has to work overtime making a wage of $35.21 per hour.

The main goal of a legal assistant, like a custodian, is to maximize utility, generally through some optimal bundle of leisure and labor. However, the main goal of a law firm is to win cases. These very different objectives can create principle-agent problems. One potential problem could arise if the firm requires more hours from our legal assistant than she wants to work per week. In order to have the best chances of winning a case, lawyers will want to come to trial with as much research and preparation as possible, so our lawyer will rely on our legal assistant to provide him with as much information as she can. Especially before a big trial, this could mean that our legal assistant would be expected to work overtime in order to research as much as possible before the trial. Therefore, overtime hours would be required on a regular basis for our legal assistant, and she would have to potentially spend more time on labor than the amount that maximizes her utility, a clear instance of the principle-agent problem. The fact that the Fair Labor Standards Act requires overtime pay of time and one-half of the regular pay partially serves as a remedy to this problem. Receiving more pay for these overtime hours makes working them more worthwhile. However, another way to further help this problem would be if the firm created rules that designate a maximum number of hours employees can work per week. This would prevent our legal assistant from being expected to work a ridiculous amount of hours, and hopefully this restriction would allow her to be closer to her optimal amount of time spent on labor.

Another potential principle-agent problem for our legal assistant involves ethical issues. Because the primary objective of a law firm is to win cases, this desire to win could lead some firms to use illegal or unethical means to reach this goal. Rule 5.3 of the American Bar Association’s Model Rules of Professional Conduct states that lawyers can get in trouble if their legal assistants or other staff members participate in illegal behavior. However, illegal or unethical behavior by an assistant could give a lawyer a distinct advantage, without facing the guaranteed disbarment that would occur if the lawyer directly participated in the behavior. This pressure on legal assistants to participate in illegal or unethical behavior luckily does not occur very commonly, but this example demonstrates another form of the principle-agent problem. The forced participation in illegal or unethical behavior for her law firm would certainly decrease the utility and happiness of our legal assistant. She would feel uncomfortable and be in danger of getting in federal trouble, and this would lead to high stress levels and resentment towards the law firm. This problem could be solved by simply having strict rules within the firm that punish illegal behavior. Another way to prevent this problem that requires more of a long term reform is to establish a culture within the firm that looks down upon illegal and unethical behavior. This example demonstrates that the principle-agent problem can go past the amount of hours of labor or leisure performed by workers but also involves the emotions of workers themselves.

These examples demonstrate the effects of principle-agent problems and the way that these problems can affect the lives of workers. While these instances primarily examined how principle-agent problems negatively impact the utility of workers in firms, they also can negatively impact firms as well. Both legal assistants and custodians are generally paid by the hour, so firms can use efficiency wages in order to guarantee that workers will be as productive as possible. In contrast, in the cases of salary workers, an example of a principle-agent problem is when these workers shirk in order for them to increase their amount of leisure, resulting in the productivity of the firm being hurt. This general example, along with the more detailed instances of principle-agent problems for legal assistants and custodians that we examined, show how big of an issue these principle-agent problems can be. However, these problems can easily be fixed with restrictions on firms and changes in remuneration schemes if their existence is acknowledged, so hopefully firms will find more and more ways to address these problems in the future.

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