Principal-agent theory - Revision history

Designing Buildings at 09:35, 30 October 2020

2020-10-30T09:35:04Z

← Older revision		Revision as of 09:35, 30 October 2020
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	= Introduction =		= Introduction =

−	~~The principal~~-agent theory is a management model that can be applied to construction projects. ~~This theory~~ looks at the relationship between the principal (who may be the project owner or ~~boss~~) and the agent (who is the contractor or other entity). Because the principal wants something done but cannot complete the task, the agent is hired.	+	Principal-agent theory is a management model that can be applied to construction projects. It looks at the relationship between the principal (who may be the project owner or client) and the agent (who is the contractor or other entity). Because the principal wants something done but cannot complete the task, the agent is hired.

−	The principal-agent model has been highly influential in theory and practice alike. It is the subject of a significant ~~amount of~~ continuing research, particularly as it relates to the combination of contract methods and risk management that can limit the principal's risk exposure.	+	The principal-agent model has been highly influential in theory and practice alike. It is the subject of significant continuing research, particularly as it relates to the combination of contract methods and risk management that can limit the principal's risk exposure.

	= Research and theory development =		= Research and theory development =

−	The ~~introduction of the~~ principal-agent theory ~~goes~~ back to the 1970s ~~with~~ the work of Michael C Jensen and William H Meckling. In their paper ~~entitled~~, T[https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf heory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure], Jensen and Meckling “...define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent. In addition in some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions. However, it is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint. In most agency relationships, the principal and the agent will incur positive monitoring and bonding costs (non-pecuniary as well as pecuniary), and in addition there will be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal.”	+	The principal-agent theory dates back to the 1970s and the work of Michael C Jensen and William H Meckling. In their paper, T[https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf heory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure], Jensen and Meckling “...define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent. In addition in some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions. However, it is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint. In most agency relationships, the principal and the agent will incur positive monitoring and bonding costs (non-pecuniary as well as pecuniary), and in addition there will be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal.”

−	Additional noteworthy research in the area has been conducted by Stephen A Ross (1973) and James A Mirrlees (1976). However, it is Joseph E Stiglitz (1975) who credits Ross for identifying - and clarifying - the underlying problem of principal-agent theory.	+	Additional noteworthy research in the area has been conducted by Stephen A Ross (1973) and James A Mirrlees (1976). However, it is Joseph E Stiglitz (1975) who credits Ross for identifying and clarifying the underlying problem of principal-agent theory. Stiglitz wrote, "A principal-agent problem arises when there is imperfect information, either concerning what action the agent has undertaken or what he should undertake. In many situations, the actions of an individual are not easily observable."
−		+
−	Stiglitz ~~writes~~, "A principal-agent problem arises when there is imperfect information, either concerning what action the agent has undertaken or what he should undertake. In many situations, the actions of an individual are not easily observable."	+

	= Managing risk =		= Managing risk =

−	Both the principal and the agent ~~will~~ look to minimise risk; ~~this is usually a primary priority~~ during construction. However, the principal may be exposed to hidden risk ~~caused~~ by asymmetric communication of information (as identified by Stiglitz) which may occur if the agent is better informed about the specifics of the project than the principal.	+	Both the principal and the agent look to minimise risk; often one of the main priorities during construction. However, the principal may be exposed to hidden risk by asymmetric communication of information (as identified by Stiglitz) which may occur if the agent is better informed about the specifics of the project than the principal.
−		+
−	The agent may be better informed in areas related to cost reduction measures taken in order to obtain incentives. While some incentives will motivate the agent to improve efficiency, they may also result in actions that increase risk to the project.	+

−	~~When delegating a task to the~~ agent~~, the principal~~ may ~~not~~ be ~~aware of the agent’s capabilities before the contract is~~ in ~~place, nor can the principal know what it~~ will ~~be at~~ the ~~post-contract phase (as~~ also ~~identified by Stiglitz). In this instance, how far can the~~ risk ~~be transferred~~ to the ~~agent?~~	+	The agent may be better informed, for example, in areas related to cost reduction measures taken in order to obtain incentives. While some incentives will motivate the agent to improve efficiency, they may also result in actions that increase risk to the project.

−	~~For~~ the ~~sake of~~ the ~~project (and the preservation~~ of the ~~working relationship)~~ is ~~beneficial~~ to ~~ensure~~ risk ~~allocation is chosen appropriately under this arrangement.~~	+	When delegating a task to the agent, the principal may not be aware of the agent’s capabilities before the contract is in place, nor can the principal know what it will be at the post-contract phase. So, to what extent should risk be transferred to the agent?

	= Related articles on Designing Buildings Wiki =		= Related articles on Designing Buildings Wiki =

Editor at 18:44, 29 October 2020

2020-10-29T18:44:26Z

← Older revision		Revision as of 18:44, 29 October 2020
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	The principal-agent theory is a management model that can be applied to construction projects. This theory looks at the relationship between the principal (who may be the project owner or boss) and the agent (who is the contractor or other entity). Because the principal wants something done but cannot complete the task, the agent is hired.		The principal-agent theory is a management model that can be applied to construction projects. This theory looks at the relationship between the principal (who may be the project owner or boss) and the agent (who is the contractor or other entity). Because the principal wants something done but cannot complete the task, the agent is hired.

−	The principal-agent ~~theory~~ has been highly influential in theory and practice alike. It is the subject of a significant amount of continuing research, particularly as it relates to the combination of contract methods and risk management that can limit the principal's risk exposure.	+	The principal-agent model has been highly influential in theory and practice alike. It is the subject of a significant amount of continuing research, particularly as it relates to the combination of contract methods and risk management that can limit the principal's risk exposure.

	= Research and theory development =		= Research and theory development =
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	= Managing risk =		= Managing risk =

−	Both the principal and the agent will look to minimise risk; this is usually a primary priority during construction. However, the principal may be exposed to hidden risk caused by asymmetric communication of information which may occur if the agent is better informed about the specifics of the project than the principal.	+	Both the principal and the agent will look to minimise risk; this is usually a primary priority during construction. However, the principal may be exposed to hidden risk caused by asymmetric communication of information (as identified by Stiglitz) which may occur if the agent is better informed about the specifics of the project than the principal.

	The agent may be better informed in areas related to cost reduction measures taken in order to obtain incentives. While some incentives will motivate the agent to improve efficiency, they may also result in actions that increase risk to the project.		The agent may be better informed in areas related to cost reduction measures taken in order to obtain incentives. While some incentives will motivate the agent to improve efficiency, they may also result in actions that increase risk to the project.

−	When delegating a task to the agent, the principal may not be aware of the agent’s capabilities before the contract is in place (nor can the principal know what it will be at the post-contract phase). In this instance, how far can the risk be transferred to the agent?	+	When delegating a task to the agent, the principal may not be aware of the agent’s capabilities before the contract is in place, nor can the principal know what it will be at the post-contract phase (as also identified by Stiglitz). In this instance, how far can the risk be transferred to the agent?

−	~~The principal-agent theory suggests that~~ the ~~optimal risk-sharing ratio be set at~~ the ~~level where~~ the ~~total surplus from the transaction can be maximised under the constraints~~ of ~~participation and incentive compatibility. It~~ is beneficial to ensure risk allocation is chosen appropriately under this arrangement.	+	For the sake of the project (and the preservation of the working relationship) is beneficial to ensure risk allocation is chosen appropriately under this arrangement.

	= Related articles on Designing Buildings Wiki =		= Related articles on Designing Buildings Wiki =
		+
		+	* Agent.
		+	* Conflict of interest.
		+	* Construction contract.
		+	* Overcoming difficulties in construction value management.
		+	* Principal contractor.
		+	* Types of risk in construction projects.

	= External resources =		= External resources =

Editor at 18:37, 29 October 2020

2020-10-29T18:37:06Z

← Older revision		Revision as of 18:37, 29 October 2020
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	The principal-agent theory has been highly influential in theory and practice alike. It is the subject of a significant amount of continuing research, particularly as it relates to the combination of contract methods and risk management that can limit the principal's risk exposure.		The principal-agent theory has been highly influential in theory and practice alike. It is the subject of a significant amount of continuing research, particularly as it relates to the combination of contract methods and risk management that can limit the principal's risk exposure.

−	= ~~Jensen~~ and ~~Meckling~~ =	+	= Research and theory development =

	The introduction of the principal-agent theory goes back to the 1970s with the work of Michael C Jensen and William H Meckling. In their paper entitled, T[https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf heory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure], Jensen and Meckling “...define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent. In addition in some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions. However, it is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint. In most agency relationships, the principal and the agent will incur positive monitoring and bonding costs (non-pecuniary as well as pecuniary), and in addition there will be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal.”		The introduction of the principal-agent theory goes back to the 1970s with the work of Michael C Jensen and William H Meckling. In their paper entitled, T[https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf heory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure], Jensen and Meckling “...define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent. In addition in some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions. However, it is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint. In most agency relationships, the principal and the agent will incur positive monitoring and bonding costs (non-pecuniary as well as pecuniary), and in addition there will be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal.”

Editor at 18:36, 29 October 2020

2020-10-29T18:36:21Z

← Older revision		Revision as of 18:36, 29 October 2020
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	The introduction of the principal-agent theory goes back to the 1970s with the work of Michael C Jensen and William H Meckling. In their paper entitled, T[https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf heory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure], Jensen and Meckling “...define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent. In addition in some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions. However, it is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint. In most agency relationships, the principal and the agent will incur positive monitoring and bonding costs (non-pecuniary as well as pecuniary), and in addition there will be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal.”		The introduction of the principal-agent theory goes back to the 1970s with the work of Michael C Jensen and William H Meckling. In their paper entitled, T[https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf heory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure], Jensen and Meckling “...define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent. In addition in some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions. However, it is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint. In most agency relationships, the principal and the agent will incur positive monitoring and bonding costs (non-pecuniary as well as pecuniary), and in addition there will be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal.”

−	~~Subsequent~~ research in the area has been conducted by ~~Mirrlees (1976),~~ Ross (1973), and ~~Stiglitz~~ (~~1975~~). It is ~~well reviewed by Prendergast~~ (~~1999~~) and~~, in~~ the ~~case~~ of ~~Mirrlees’ seminal work~~, ~~by Besley and Dixit (1997)~~.	+	Additional noteworthy research in the area has been conducted by Stephen A Ross (1973) and James A Mirrlees (1976). However, it is Joseph E Stiglitz (1975) who credits Ross for identifying - and clarifying - the underlying problem of principal-agent theory.
		+
		+	Stiglitz writes, "A principal-agent problem arises when there is imperfect information, either concerning what action the agent has undertaken or what he should undertake. In many situations, the actions of an individual are not easily observable."

	= Managing risk =		= Managing risk =
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	* Michael C Jensen and William H Meckling, [https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure].		* Michael C Jensen and William H Meckling, [https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure].
		+	* James A Mirrlees, [https://www.jstor.org/stable/3003192?seq=1 The Optimal Structure of Incentives and Authority within an Organization].
		+	* Stephen A. Ross, [https://www.jstor.org/stable/1817064?seq=1 The Economic Theory of Agency: The Principal's Problem].
		+	* Joseph E Stiglitz, [https://link.springer.com/chapter/10.1007/978-1-349-20215-7_25 Principal and Agent].

	[[Category:DCN_Definition]] [[Category:Theory]] [[Category:Client_procedures]] [[Category:Construction_management]] [[Category:Contracts_/_payment]] [[Category:Public_procedures]] [[Category:Roles_/_services]]		[[Category:DCN_Definition]] [[Category:Theory]] [[Category:Client_procedures]] [[Category:Construction_management]] [[Category:Contracts_/_payment]] [[Category:Public_procedures]] [[Category:Roles_/_services]]

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= Introduction =

The principal-agent theory is a management model that can be applied to construction projects. This theory looks at the relationship between the principal (who may be the project owner or boss) and the agent (who is the contractor or other entity). Because the principal wants something done but cannot complete the task, the agent is hired.

The principal-agent theory has been highly influential in theory and practice alike. It is the subject of a significant amount of continuing research, particularly as it relates to the combination of contract methods and risk management that can limit the principal's risk exposure.

= Jensen and Meckling =

The introduction of the principal-agent theory goes back to the 1970s with the work of Michael C Jensen and William H Meckling. In their paper entitled, T[https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf heory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure], Jensen and Meckling “...define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent. In addition in some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions. However, it is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint. In most agency relationships, the principal and the agent will incur positive monitoring and bonding costs (non-pecuniary as well as pecuniary), and in addition there will be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal.”

Subsequent research in the area has been conducted by Mirrlees (1976), Ross (1973), and Stiglitz (1975). It is well reviewed by Prendergast (1999) and, in the case of Mirrlees’ seminal work, by Besley and Dixit (1997).

= Managing risk =

Both the principal and the agent will look to minimise risk; this is usually a primary priority during construction. However, the principal may be exposed to hidden risk caused by asymmetric communication of information which may occur if the agent is better informed about the specifics of the project than the principal.

The agent may be better informed in areas related to cost reduction measures taken in order to obtain incentives. While some incentives will motivate the agent to improve efficiency, they may also result in actions that increase risk to the project.

When delegating a task to the agent, the principal may not be aware of the agent’s capabilities before the contract is in place (nor can the principal know what it will be at the post-contract phase). In this instance, how far can the risk be transferred to the agent?

The principal-agent theory suggests that the optimal risk-sharing ratio be set at the level where the total surplus from the transaction can be maximised under the constraints of participation and incentive compatibility. It is beneficial to ensure risk allocation is chosen appropriately under this arrangement.

= Related articles on Designing Buildings Wiki =

= External resources =

* Michael C Jensen and William H Meckling, [https://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure].

[[Category:DCN_Definition]] [[Category:Theory]] [[Category:Client_procedures]] [[Category:Construction_management]] [[Category:Contracts_/_payment]] [[Category:Public_procedures]] [[Category:Roles_/_services]]