I wanted to do a quick post on a little bit of knowledge that everyone would be wise to study. If you want to know why contractors are paid as much as they are paid then definitely wrap your brain around the concept of Principal-Agent Theory and what it all means. It all boils down to ‘ensuring the provision of appropriate incentives so agents act in the way principals wish’.
By the way, I picked up on this thing while reading a paper that David Isenberg commented on in a blog post. The paper was about Security Sector Reform (SSR) and the author mentioned Principal-Agent Theory towards the end of it. The author did a study on DynCorp/PAE’s SSR mission for DoS in Liberia, and it was an interesting read. Check it out. –Matt
In political science and economics, the problem of motivating a party to act on behalf of another is known as ‘the principal–agent problem’. The principal–agent problem arises when a principal compensates an agent for performing certain acts that are useful to the principal and costly to the agent, and where there are elements of the performance that are costly to observe. This is the case to some extent for all contracts that are written in a world of information asymmetry, uncertainty and risk.
Here, principals do not know enough about whether (or to what extent) a contract has been satisfied. The solution to this information problem — closely related to the moral hazard problem — is to ensure the provision of appropriate incentives so agents act in the way principals wish.
In terms of game theory, it involves changing the rules of the game so that the self-interested rational choices of the agent coincide with what the principal desires. Even in the limited arena of employment contracts, the difficulty of doing this in practice is reflected in a multitude of compensation mechanisms (‘the carrot’) and supervisory schemes (‘the stick’), as well as in critique of such mechanisms as e.g., Deming (1986) expresses in his Seven Deadly Diseases of management. A distinct and relatively new meaning of the principal–agent problem describes the landlord-tenant relationship as a barrier to energy savings.
This use of the term is described below in the section on the principal–agent problem in energy efficiency. The problem is also discussed in terms of “agency theory”.
Wikipedia for Principal-Agent Theory here.