AGENCY PROBLEMS IN PUBLIC SECTOR György Attila Bucharest Academy of Economic Studies Faculty of Finance, Assurance, Banks and Stock Exchange Agency theory analyses the effects of contractual behaviour between two parties: principal(s) and agent(s). This relation is inevitably characterized by information asymmetry because agent holds a substantially larger volume of information than the principal. Due the negative effects of information asymmetry for the principal, this should cover supplementary costs with monitoring agents and/or grant incentives. The first objective of this paper is to emphasize the effects of information asymmetry, particularly on adverse selection and moral hazard. The second objective is to evaluate the negative effects of information asymmetry and to assess the viability of solutions proposed by scholars for mitigation. The third objective is linked with personal contribution, respectively to highlight specificity of agency theory in public sector and the mechanisms of action in this particular field. In this paper, literature is mainly based on scholars’ contribution to the proposed theme. Little literature approaches agency theory in public sector, in most cases the analysis being restricted to general issues. Research methodology is based on synthesizing relevant information from literature and adapting them to public sector particularities. The results reflect some threats for public bodies in their contracting activity. Conclusions present also a set of solutions which could be used by public institutions to optimize their activity of mitigating information asymmetry’s effects. These solution guidelines could represent a useful instrument for make more efficient public money spending. Personal contribution and the novelty of this paper consist in presenting a new approach regarding mechanisms of managing information by agents. In case of public institutions, principals have more opportunities the take possession over the information managed by the agent. Nevertheless, agents can limit the principal’s access to vital information by offering excessively much information, combining few vital data with numerous unimportant information. For further research, agent’s information management should be depth and analyzed in which manner principal can control it. Keywords: agency theory, information asymmetry, adverse selection, moral hayard, public resources JEL Codes: D01, H59

Introduction Studying the current economic phenomena is a concern that arose from the need of understanding the economic reality and find levers, instruments with which to intervene for the control of this dysfunction (Câmpeanu et al. 2011: 42). Some distortions are generated by the behaviour of participants in economy which establish in contracts the mutual rights and obligations. The financial perspective over the contracting in economy, known as agency problems, presumes a monetization which can be made using costs supported by all parties. Agency theory has been used in numerous fields such as accounting, economics, finance, marketing, political science, organizational behaviour, sociology (Eisenhardt 1989: 57), which recommend it as a complex analyse tool. Agency costs arise from many sources: the costs of recruitment, adverse selection, specifying and discerning preferences, providing incentives, moral hazard, shirking, stealing, self-dealing, corruption, monitoring and policing, self-regulation, bonding and insurance, agents who oversee agents, as well as failures in these costly corrective devices (Shapiro 2005: 281). Agency costs are strongly related to information problems, three of them deserving close consideration: adverse selection, moral hazard and non-verifiability because each of those informational problems leads to a different paradigm and, possibly, to a different kind of agency costs (Laffont and Martimort 2001: 14). Non-verifiability can be associated with moral hazard because it inseparably linked with unobservability. In most cases, the public sector principals contract a certain quantity of public services from their agents. These quantities are derived from public policies and should be fulfilled without exceeding them. In order to maximize efficiency, principals should monitor agents in order to obtain minimal resource consumption for offering contracted quantity of public services. 708

Optimization of agency problems requires new categories of costs in order to reduce significantly the negative effects on costs produced directly by agents. Thus, agency problems may be solved, at a cost, with the use of incentive compensation, monitoring, and signalling by the agent (Chua et al. 2009: 359). Adverse selection The adverse selection models present situations where the decisions of player (named the Agent) having private information depend on private information and could negatively affect others participants; the party making the contractual offer and who doesn’t know the Agent’ private information is attempting to reduce this informational disadvantage (Marinescu and Marin 2011: 34). Although the agent has private information, his advantage is limited because the actions it performs can be observed (Zhang and Stefanos 2008: 1). The relationship between the principal and the agent(s) involves two main types of variables: the first type is associated with a decision (or action) and is observable. The variable of the second type has generally the meaning of money transfer from the principal to the agent (Araujo and Moreira 2000: 7). In public sector, adverse selection has some specific valences. The contractual relation is set up mainly between an agent which is subordinated to the principal. The subordination relationship could be different, a large scale of parameters being possible to be meet. Mostly, the agent is created by the principal and is supported by it. The management of the agent could be designated by the principal or should be approved by it (in case of more democratic and independent organizational structures). If we look at financial issues, the general rule is that of principal’s supervision on agent’s financial activity. If agent is granted with fiscal public resources, the granting operation is coordinated entirely by the principal. As presented above, the situation looks to advantage principal’s position and to contribute to easily minimize the information asymmetry’s effects. In reality, it seems that adverse selection is due to: bureaucratic procedures, overwhelming volume of paperwork which accompanies every step of agents’ activity and principal’s conviction regarding the large possibility scale of monitoring agents. A different approach of adverse selection in public sector can be met when public authorities buy goods and services. Public procurement rules can not diminish until disappearance the information asymmetry. Adverse selection occurs when the government accepts the bid of an inefficient producer because it cannot observe the bidders’ expected production costs before awarding the contract (Cox et al. 1996: 148). Adverse selection’s profile in private and public sector seems to be different although the causes and mechanisms are similar. Information asymmetry appears not only due to holding private information (as in private sector often is meet), but also due to bureaucratic procedures which hinder to pierce basic information from a multitude papers and facts with low interest level for the principal. Moral hazard Moral hazard has an economic equivalent in a rational behaviour in terms of organization or person. Moral hazard involves a rational behaviour, namely self-interest, which could be characterized as opportunistic because it takes advantage of an opportunity for personal benefit, even if it is detrimental to others. Personal benefit is to be read more generally to refer to the benefit of the active party, whether an individual or a company (Dow 2010: 2). Moral hazard (hidden action) appears when agents may not deliver on they tasks properly due to an imperfect monitoring by the principal (Barbagallo and Comuzzi 2008: 8) and abusing of information which is only in its possession. Under these information asymmetry, the principal should spend supplementary resources in order to control agent by supervision. Soft supervisory 709

information helps the principal even though the supervisor and the supervised agent collude if this collusion takes place under asymmetric information (Faure-Grimaud, Laffont and Martimort 2003: 272). In adverse selection models, it is not the informed party (the agent) that moves first, but instead the uninformed party takes action first (Wahrenburg 1999:3). When the agent’s action is not observable, the parties design the optimal contract to maximize their joint benefits while mitigating moral hazard (Pobletey and Spulber 2011: 3). Gifford (1999: 427) consider that one of the primary conclusions of the principal-agent model of moral hazard is that, because the agent receives only a partial share of the benefits generated from the agent’s effort, which is not perfectly observed by the principal, and yet bears the entire cost of that effort, the optimal incentive contract between the principal and agent cannot achieve a first-best outcome. That is, the agent will not maximize the total value of the endeavour. In case of public procurements, moral hazard is also observable after the contract is entering into force. Moral hazard arises after the contract has been awarded because the government cannot observe all aspects of the firm’s efforts to hold down production costs, and hence the enforceable terms of the contract may not provide sufficient incentive for the firm to adopt the efficient level of cost-reducing effort (Cox et al. 1996: 148). In public sector, moral hazard is increased by the financial mechanisms which are set to supply public institutions which become agents in their contractual relations. Budgetary ex-ante allotments allow agents to feel a certainty which generate a different behaviour than rational and optimal from principal point of view. Information asymmetry causing adverse selection and moral hazard In practice, the relation between principal and agent is not divided in two components, respectively adverse selection and moral hazard. The theory, trying to explain the complexity of the situation, describes separately these information asymmetry effects. Adverse selection problems arise from information asymmetry before and/or after contracting, while moral hazard problems stem from the unobservability of managerial effort only after contracting (Sung 2005: 1021). Both, adverse selection and moral hazard have the origin in information asymmetry. If cause could be controlled or even annihilated, the pernicious effects will not appear with same raised intensity. Incentives are mechanisms which contribute to limit negative effects of information asymmetry. These mechanisms should not action individually. Some scholars consider that incentives cold be partially replaced by the forces of market which can control moral hazard (Jeon 1996: 298). In no situation, market can correct information asymmetry’s pernicious effects. In these circumstances, incentives are welcomed. The existence of incentives implies new costs for the principal. The principal–agent model could be used to model incentives in organizations (de la Rosa 2011: 429). The main costs come to the principal in terms of the incentive he provides the agent to act in the principal's interest (Van Horn 2011: 14). Scholars concluded that incentive allotment is the best solution if we compare effects with efforts. The incentives can be designed in various forms, but main options remains financial incentives. Itoh (1993: 31) stresses on non-financial incentives which could help principal in supervising agent’s behaviour. These kinds of incentives could not be used in a large scale, but in particular situations it represents a viable alternative. Itoh propose promotion to more visible tasks and evaluation of supervisors based on their subordinates' future performance could alleviate their incentives to misrepresent information via collusion, without losing benefits from cooperation among agents. Another possibility is the use of job rotations both within and across work groups. Exclusively referring to the public sector, we can observe that this field is excessively regulated. The explanation of this degree of regulation can be found in the numerous attempts to use incorrectly and inefficiently the public money. Under these circumstances, information 710

asymmetry is met also as an effect of excessive bureaucratic paperwork which hinders monitoring activity. Principals should organize information asymmetry mitigation. The two main instruments recommended to be used, as presented above, are monitoring and incentives. Both of them are costly for the principal. Under these conditions, the main challenge for the principal is to find the optimal ratio between these two instruments in comparison with results obtained in information asymmetry diminishes. For further research, stress should be put on the management of information at agent level. Principal will optimize supervision and information asymmetry diminishing when will be able to receive only vital and relevant data from the agent. Conclusion Contractual relations generate agency problems (adverse selection and moral hazard) which have the origin in information asymmetry between the parties. This information asymmetry causes negative repercussions on principal because agent will not be interested to maximize principal’s welfare, but its own prosperity. In order to mitigate information asymmetry’s effects, principal will support supplementary costs with monitoring agent or granting incentives. The big challenge for the principal is to find the optimal ratio between these categories of costs in comparison with the beneficial effects of controlling agent’s activity. In case of public sector there are some particularities regarding the relation between principals and agents. This excessively regulated field tends to accentuate information asymmetry due to the enormous volume of bureaucratic paperwork which requires costs to be assessed and used in monitoring activity. Acknowledgement This work was co-financed from the European Social Fund through Sectoral Operational Programme Human Resources Development 2007-2013, project number POSDRU/89/1.5/S/56287 „Postdoctoral research programs at the forefront of excellence in Information Society technologies and developing products and innovative processes”, partner Bucharest Academy of Economic Studies – Research Center for “Analysis and Regional Policies”. Scientific coordinator: prof. Gheorghe Zaman, PhD – corresponding member of Romanian Academy. References: [1] Araujo, Aloisio and Moreira, Humberto. Adverse Selection Problems without the Single Crossing Property. Econometric Society World Congress 2000 Contributed Papers 2000. [2] Barbagallo, Donato and Comuzzi, Marco. Towards Understanding the Role of Adverse Selection and Moral Hazard in Automated Negotiation of Service Level Agreements. Presented at SIPE’08 Conference, 2008. [3] Câmpeanu, Emilia Mioara, Gherghina, Rodica and Pădurean, Elena. „Distortions in The Empirical Investigation of Economic Phenomena”. Romanian Statistical Review vol. 10, 2011. [4] Chua Jess H., Chrisman James J. and Bergiel Erich B. An Agency Theoretic Analysis of the Professionalized Family Firm. Entrepreneurship Theory And Practice, Baylor University, 2009. [5] Cox, James C., Isaac, R. Mark, Cech, Paula-Ann and Conn, David. Moral Hazard and Adverse Selection in Procurement Contracting. Games and Economic Behavior vol. 17, 1996. [6] de la Rosa, Leonidas Enrique. ”Overconfidence and moral hazard”. Games and Economic Behavior vol. 73, 2011. [7] Dow, Sheila C. Moral Hazard and the Banking Crisis. Presented at FMM Conference, Berlin, 29-30 October 2010.


[8] Gifford, Sharon. „Efficient moral hazard”. Journal of Economic Behavior & Organization vol. 40, 1999. [9] Eisenhardt, Kathleen M. “Agency Theory: An Assessment and Review“. The Academy of Management Review vol. 14 (1), 1989. [10] Faure-Grimaud, Antoine, Laffont, Jean-Jacques and Martimort, David. Collusion, Delegation and Supervision with Soft Information. The Review of Economic Studies, vol. 70 (2), 2003. [11] Itoh, Hideshi. Coalitions, Incentives, And Risk Sharing. Journal of Economic Theory vol. 60 (2), 1993. [12] Jeon, Seonghoon. Moral hazard and reputational concerns in teams: Implications for organizational choice. International Journal of Industrial Organization vol. 14, 1996. [13] Laffont, Jean-Jacques and Martimort, David. The Theory of Incentives I: The PrincipalAgent Model, 2001. [14] Marinescu, Daniela and Marin, Dumitru. “Adverse Selection Models with Three States of Nature”. Theoretical and Applied Economics no. 555, 2011. [15] Pobletey, Joaquín and Spulberz, Daniel. The Form of Incentive Contracts: Agency with Moral Hazard, Risk Neutrality and Limited Liability. 2011. [16] Shapiro, Susan P. Agency Theory. Annual Review of Sociology vol. 31, 2005. [17] Sung Jaeyoung. Optimal Contracts under Moral Hazard and Adverse Selection: a Continuous-Time Approach. Review of Financial Studies vol. 18 (3), 2005. [18] Van Horn, Tyler G. The Utility of Freedom: A Principal-Agent Model for Unconventional Warfare. Naval Postgraduate School, 2011. [19] Wahrenburg Mark. Financial Contracting with Adverse Selection and Moral Hazard. Goethe-Universität Working Paper, 1999. [20] Zhang, Hao and Zenios, Stefanos. “A Dynamic Principal-Agent Model with Hidden Information: Sequential Optimality through Truthful State Revelation”. Operations Research vol. 56 (3), 2008.




AGENCY PROBLEMS IN PUBLIC SECTOR György Attila Bucharest Academy of Economic Studies Faculty of Finance, Assurance, Banks and Stock Exchange Agency th...

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