Last edited 30 Oct 2020

Principal-agent theory

1 Introduction
2 Research and theory development
3 Managing risk
4 Related articles on Designing Buildings Wiki
5 External resources

[edit] Introduction

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 significant continuing research, particularly as it relates to the combination of contract methods and risk management that can limit the principal's risk exposure.

[edit] Research and theory development

The principal-agent theory dates back to the 1970s and the work of Michael C Jensen and William H Meckling. In their paper, Theory 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. 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."

[edit] Managing risk

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, 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.

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?