This week I had the pleasure to read the article of Eric Posner named Coase Lecture: Agency Models in Law and Economics. The author brings us a nice and simple explanation about Agency Models and its problems, some possible solutions, and how it is the application in law, principally in contract law.
If you did not read Coase, no problem, the article in the beginning presents in summary the theory. The theory is about agency models and agency relationships – this last is explained as “a relationship in which one person, the principal, benefits when another person, the agent performs some task with care or effort”.
The basic problem is the agent represents the principal’s interests and the principal wants the agent to work hard, but the agent, normally, does not want to work hard or to give to the task his best efforts – so, how can the principal figure out a way to get the agent to work hard for the principal?
There are some solutions. The first one is to monitor the agent and fire him or her is they do not do a good job. However, monitoring it is not simple, imagine you contract a lawyer, how can you know the lawyer is doing a good job if you do not know about law and procedure?
Another problem is: monitoring is expensive. Another possibility is to give some time to the person to do the task, but this is difficult too, because, sometimes, it may happen something that could interfere the job.
The solution for these problems, or partial solution, is to design a contract that gives the rights incentives to the agent. Ok, you can think it is easy, but you are facing this solution in superficial in a perfect world.
In the real world, when there are many agents, many principals and many relationships and different effort levels of the agent, the contract is just taken as a baseline to try to solve problems. The contract must be a way to make incentives, or like Posner said: “design a contract that makes compensation depend on the output of the agent”.
The best insight I had about reading this amazing article is the importance of drafting a contract that represents the reality of the relationship or the negotiation among the parties, to understand the obligations of each of them, the incentives that you need to think to make the agent give the best effort; besides, to prevent possible hold-ups. In simple words: it is impossible to get a contract template and believe it is protecting your rights!
The last insight of this article, I will rewrite below:
“In any agency relationship there will be potential agency costs, which can be minimized through clever monitoring and clever design of the contract that trades off incentives, on the one hand, and insurance, on the other”.
Contracts are important, but just clever design contract make the difference!
If you were really interested, here the article:
Dra. Samanta Calegari