Regulation and the Principle Agent Dilemma

Dear Friends,

It seems to me that Chief Executive Officers, COEs, of large corporations have many of the privileges as owners of large companies, but have none of the responsibilities. As we see empirically with teenagers, people who are given freedom, without responsibility, often run amok. Perhaps this is a large part of why the corporate structure of today’s firms show such a divergence from the will of the principles, (the stock holders). This is often described as the “Principle/Agent dilemma.” This question and the questions it brings up have great import to the economic well being of humanity.

Of course there are some responsibilities for a CEO but they pale in comparison to that of an owner. An owner is actually personally responsible for his or her company. But the CEO has many layers of responsible people under him or her. They sometimes get responsibility when a corporation is caught,. Enron and MCI are the only two I can think of readily, where the CEO was held responsible. But, wait, the CEO of MCI was the owner, and the CEO of Enron was also an owner… Goldman or JP Morgan?

The modern CEO, more often than not, is paid far higher than most owners… historically. So we can safely say some CEOs are paid more, as a percent of profit, then some owners. With higher pay and less personal responsibility, the modern CEO, (agent) has less incentive to meet the needs of the stockholders (principle). As the group of CEOs that fall within the some that make more as a percentage of profits than an owner then we can safely say, that the interests that those corporations are governed for, will increasingly be for the agents and not the principles. In fact the very actuality of a CEO getting paid more than an owner of a similar company in size, scope, profits and industry, prove that that company, at least, is governed in the interests of the agents not the principles.

Government could address this problem and many others by adopting a new paradigm for regulation. Take for example the modern incarnation of regulation, “A minimum 5/8 inch nylon braded rope must be used to lash. The lashing must be 6 turns per linear foot, with 2 inch spacing…” Regulated to the minutest detail. Now I have no problem with government researching best practices but regulating to the nth detail is absurd. One problem with it is It stifles innovation for better practices.

Maybe a better way would be to regulate outcomes. Instead of regulating how a thing is done regulate the results of it’s manufacture. Take the rigging industry. There is a common set of safety standards and well researched levels of injuries. We can say that there is a background level of injuries in any industry. This level of background of injuries would form the basis of outcome based regulation. Lets say for arguments sake, that there are 10 major injuries per 10,000 hours worked in Abc industry with 1 death. If we base regulation on an injury rate of 1/10,000 and regulate Abc industry accordingly, then if the rate of injuries exceeds that rate then the industry is drastically penalized.

But don’t fine the shareholders, fine the CEO and board of directors, threaten the top corporate brass with jail. If the injury rate goes up beyond a certain set point then the CEO would be held personally responsible for the increase in injuries. This is the only way to back off on some safety regulation. Otherwise, people being people, safety would immediately slack off and the rate of industrial accidents would skyrocket. But if outcome based regulation were enacted, first, (it exists in a lesser form today), and advertised it, the background rate of industrial accidents could be lowered while the productivity of our industries would be raised.

With the positive externality of better corporate governance. The potential of lower accident rates, or any other rate that regulation seeks to mitigate, allowing a greater percent of the workforce to remain productive throughout their lifetimes, and a better handle on the corporate principle agent dilemma make this an idea who’s time has come. Let us not forget that as the productivity of a society grows so does it’s innate wealth. No matter where you are on the societal ladder if the whole ladder goes up you rise too.

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