the principal-agent problem: what it is, why it’s important, and how it can be solved

The principal-agent problem is a common problem that arises whenever there is a contractual relationship between two parties – the principal, who in accordance with agreed upon terms, assigns a task to an agent, who then executes the task for the principal. It is expected that the agent will work on the behalf of the principal. Likewise, it is expected that the principal will be honest with the agent. However, this is not always the case, ergo a problem is created of which there are two main types.

The first is an ex-post hazard which occurs after the closing of a contract. Without constant monitoring, it is possible for the agent, who with the right motivation and ability, can covertly work against the interests of the principal. A moral hazard results from this when the socially beneficial consequences are removed as a result of a lack of essential information needed to spur good behavior or discourage bad behavior. In other words, a party in the contract who is protected from some form of risk engages in behavior that they would otherwise not engage in, e.g. engaging in risky behavior by insurance holders or apathetic teachers who have received tenure. Solutions to such a problem can take the form of, for example, more sophisticated contracts or institutional arrangements; supplemental contractual components, e.g. fixed payments or performance pay; trust building; and third party involvement, e.g. insurance. However, it is important to note that the agent will likely always have information rent, i.e they will always have an informational advantage.

The second type of hazard is ex-ante and occurs before the closing of a contract. In this type of situation, the principal has the option to structure the agreement in their favor by keeping relevant and potentially damaging information from the agent. This results in adverse selection which creates an imbalance of power in favor of the party with more information. Such a problem can be rectified using, for example, a menu of contracts; additional contractual components, e.g. buy-back options; trust development; the involvement of third parties, e.g. labeling or licensing; and signaling.

In more simple terms, the principal-agent problem represents the fact that ownership ≠ control. Accordingly, institutions can need to be used in order to establish as equitable of a relationship between agent and principal as possible.

sources:

https://www.cfainstitute.org/learning/…/principal-agent_problem_in_finance.pdf
http://www.investopedia.com/terms/p/principal-agent-problem.asp
http://lexicon.ft.com/term?term=principal/agent-problem

 

what value chains are and how they can optimize economic efficiency

First introduced in 1985 by Michael Porter, the value chain concept is understood as the process by which value is added to raw materials via various production processes in order to generate a final product that can be sold for a higher price. The main components of value chains are inbound logistics, operations, outbound logistic, marketing and sales, and services.

the_value_chain_porter
Image Credit: lib.bakeru.edu

 

The way by which value chains are interpreted can take two forms. The first is in the limited scope of the activities that take place within a given business with the intention of producing a particular output. Such activities may be individual in nature or they may be conducted by cooperatives or producers working together in an effort to achieve a common goal. These activities may be also considered vertical integration or functional upgrading. From a more comprehensive perspective, value chains are a complex range of activities partaken by a wide spectrum of actors linked together by the process of bringing raw materials that have or have not been processed to consumers. Such relationships are dependent on coordination and long-term relationships as well as optimization and adding value. The aim, in either case, is the optimization of the flow of a product throughout the production process. This optimization can take the form of identifying and rectifying bottlenecks, the division of labor, reaching economies of scale or reaching established market standards. Achieving these results stimulate economic growth, indicating that the construction of value chains directly impacts competitiveness. Nonetheless, despite adding increasing value, costs are also incurred, marking the need for effective planning and strategizing in the development process.

Several factors contribute to the successful development of value chains. For instance, the presence of and protection of producer organizations can be fundamental. Likewise, strong policy and government programs can play an important role in value chain development by:

  • Providing or creating access to city/farmers markets
  • Supporting the development of green labels
  • Providing timely market info for stakeholders
  • Stipulating a preferential local procurement strategy
  • Technical (e.g. training) and financial assistance (e.g. subsidies)
  • Licensing

In order for effective value chain development to take place,  four strategic requirements must be incorporated:

  1. Market orientation
  2. A homogeneous target group
  3. Closeness/clusters
  4. Organized

Building on the aforementioned elements, three primary strategies can be implemented: processing of the product to create a product with higher value, e.g. producing jam from fruit; focusing on niche markets e.g. organics; or intervening in other parts of the value chain by focusing on a specific component of the value chain, e.g. partnering with social services. Regardless of the method chosen, it is imperative to identify and cater to the demands of the consumers in order to ensure long-term economic solvency. In doing so, not only is a strategy for economic efficiency implemented, but the needs of the market are met to effectively create a market pull.

institutions: what they are, why we need them and how they shape our everyday lives

It is a common practice in the United States to sing Happy Birthday to a person when they survive another year on this planet. However, in China, birthday celebrations commonly take the form of elaborate banquets and are reserved for the very young or very old. Despite being obviously divergent practices, they are both considered forms of institutions.

According to North (1990), “institutions are the humanly devised constraints that shape human interactions”. In other words, they are the rules of the game of life. These rules can be both formal and informal, and serve to address the interdependence of human actors on the planet by providing guidelines or requirements for conflict, cooperation and coordination. Formal institutions are de jure and legislated, e.g. common law or statutes. Contrastingly, informal institutions are, for example, norms of behaviors, conventions and internally imposed rules of conduct, e.g. customs and traditions. The implementation of institutions serves to safeguard people against opportunistic behaviors.

In this respect, formal institutions combine a particular situation with a required or forbidden act that is governed by a third party. The purpose of such institutions is to solve situations with conflicting interests. Property law, liability law or even regulations on water pollution can be considered a form of formal institution. As conventions and norms are informal in nature, there is no official third-party regulator, rather it is society, that enforces these institutions. For instance, norms combine a given situation with a required act or solution as a means to support the underlying value, indicating that norms are a protection of human values or ‘proper’ human relations, with the giving and receiving a birthday gift serving as an example. Similarly, but not as severe, conventions like language or dress codes combine a certain situation with a certain act or solution as a means to simplify life in a complex world, establish and maintain regularity, solve coordination problems or provide a tool for creating identify.

The foundational assumptions of Institutional Economics are based on several assumptions about individuals:

  • They are bounded and also intendedly rational, but not always successful in this intention
  • They are interested in a means to a given ends
  • They engage in opportunistic behavior
  • They are faced by transaction and information costs as well as variations in the quality of goods and services received
  • They are dependent on institutions to overcome information costs and safeguard them against negative behavior

Such assumptions are essential to understand, as they must be considered in the design of institutions and contracts. In this respect, it thereby becomes relevant in the comparison of the relative benefits of various institutional arrangements. Is also important to note that those who establish institutions should not independent from the rules that they implement, e.g. politicians adhering to the laws they implement, albeit this is unfortunately often not the case. Common subjects addressed by IE include:

  • Markets: Which type of contracts to use based on a given situation? How should an alternative energy market be designed?
  • Organization: How can employees be controlled or incentivized? How shall departments/subunits be organized.
  • Politics: How should utilities be regulated? How will the commons be managed?


sources:
www.geoffrey-hodgson.info/user/image/essenceinstecon.pdf
www.newworldencyclopedia.org/entry/Institutional_economics
https://www.cambridge.org/core/journals/journal-of-institutional-economics
North, D. (1990). Institutions, institutional change, and economic performance. Cambridge University Press.

business clusters: what they are and why they provide a competitive advantage

Have you ever wondered why Wall Street is known for finance or why the California wine industry has been so successful in integrating itself into the global market? In a word: clusters. Clusters are concentrations of complementary organizations, institutions and companies that are components of a given field in a specific geographic location. These conglomerations of talent, finance and resources result in an apex of success that can be contributed to their locally-sourced competitive advantage that improves the innovative capacity of said location. From another perspective, clusters can be considered an alternative way of organizing value chains in that there is both horizontal and vertical integration of the stakeholders.

This unique form of organization creates a microclimate for competition that results in increased productivity for a given area attributed to the shared stimulus and gains. Likewise, the direction of innovation and growth is driven by the speciality of the area, which serves to further catalyze the economic environment and stimulates the formation of new businesses. Such an environment is usually triggered by some form of localized development or innovation, which indicates that the quality of local businesses and the environment in which they are is essential.

Four essential components for the successful development of a cluster are as follows:

  1. An appropriate location
  2. Local engagement
  3. The promotion of and investment in upgrades
  4. Collective cooperation

Once the establishment of a cluster begins, it is then possible to solidify trust via repeated interactions (game theory). The introduction of trust in economic relations results in improved efficiency, effectiveness and flexibility. Additional benefits identified include:

  • Lower search costs and transaction costs as a result of centralized information and labor
  • Increased productivity
  • Easier sourcing and reduced storage/housing costs
  • Improved reputation
  • Access to institutions and public goods
  • Lower risk
  • Reduced

Furthermore, clusters promote robust competition and cooperation due to the fact that:

  • It is easier to measure performance as the competition is close to home
  • Healthy, local rivalries can develop to promote a ‘race of arms’ which stimulates innovation
  • Economies of scale resulting from the collaboration between a number of local actors provides incentives for economic alliances

With all the benefits provided by clusters, it is easy to understand why developing a cluster in any given sector is desirable – especially in the modern, globalized world – in order to provide the advantages necessary to maintaining a competitive edge via the intelligent use of resources and innovative methods. It is, therefore, essential to be adaptive, both internally and externally, in order to avoid rigidity and inertia. Moreover, it is important to recognize that while government interventions are often good intentions, they can also cause stagnation in further development, making it essential for members of these economic communities to develop strategies not only for business success but also for sustainability, resilience and a changing social climate.

 

cooperatives

The world we live in is quite complicated.  Being alone in this crazy, mixed-up reality can make this truth quite scary.  However,  even in the big, bad take-no-prisoners universe of globalized economics, there are tools that can be used to help improve one’s chances of successful navigation through these choppy waters. One of the most effective tools in this respect are cooperatives, which are defined in many different ways:  

Barton (2000) define cooperatives as a private business owned and controlled by users and operated principally to provide benefits to users;   

The International Co-operative Alliance (ICA) characterizes cooperatives as autonomous associations of persons united voluntarily to meet their common economic, social and cultural needs and aspirations through a jointly owned and democratically controlled enterprise;  

The US Federation of Worker Cooperatives (USFWC) identifies cooperatives as business entities controlled by their members, the people who work in them.    

There are many more definitions, but each indicates that it is the members who make a co-operative a co-operative. Therefore, there is a goal of maximized benefit for the members who comprise the constituency.  This is in contrast to standard business models in which the ultimate goal is (almost) always maximized profit.  Additionally, co-operatives are unique in that they are dual-natured – the serve both as a social group and business enterprise.   

According to the ICA, co-operatives should adhere to several principles:  

  • Voluntary and open membership  
  • Democratic member control  
  • Autonomy and independence  
  • Education, information, and training  
  • Co-operative among cooperatives  
  • Concern among community  

The USDA streamlines these qualities into 3 fundamental characteristics:  

  1. User-owned: co-operatives are used by those who own it  
  2. User-control: co-operatives should be controlled by those who use it  
  3. User-benefits: benefits generated by the co-operative are allocated to its users on the basis of use  

It is estimated that there are currently an estimated 1 billion co-operative members in the world and approximately 100 million individuals.  The largest amount of revenue generated by co-operatives in the world is related to agriculture (28.85%), although there are many other types including banking/credit unions (26.27%), consumer retail (21.66%) and insurance (17.123%).

Within these various sectors, the size and composition of the co-operative vary greatly. Regardless of this fact, members are able to enjoy many benefits associated with their membership, including (but not necessarily limited to):

  • Increased negotiation power  
  • Support for social causes (e.g., a green power co-operative)
  • Economies of scale (decreased prices as a result of more production)  
  • Risk reduction (e.g., price stabilization)  
  • Product diversification  
  • Improved and/or new access to markets  
  • Better market conditions
  • Patronage refunds
  • BETTER COST EFFICIENCY (identified as the primary motivation)

The development and use of co-operatives can also help to destabilize oligopoly markets (those in which only a small number of businesses maintain a stronghold of power making market entry for newcomers or alternative economic methods virtually impossible), which is essential in a world where power and money continues to become more and more concentrated among only a few companies and individuals.   Furthermore, when co-operatives provide better conditions for the members than traditional businesses can offer, traditional businesses must become competitive in order to avoid a scenario in which all members of a given sector join a co-operative.  This phenomenon is known as the Yardstick Effect.

To ensure that co-operatives do not transform into entities that mimic the activities of their private firm counterparts (for example, charging too much), cooperatives are democratically controlled and designed to serve as economic “architects”, rather than economic “Napoleons”.  (see Nourse, 1945)

https://usworker.coop/about/what-is-a-worker-coop  

http://ica.coop/sites/default/files/attachments/Global300%20Report%202011.pdf