The Principal Agent Problem

"A principal is an owner; an agent is an employee"

"If you want something done, do it yourself" is a phrase that captures the relationship between a Principal and its Agent. The principal is responsible for coordinating tasks for an agent, while the agent is responsible for delivering said task:

Child and parent, student and teacher, employee and boss. Principals and agents are involved throughout our lives. An important thing to realize is: we want different things to fulfill our desires.

Incentives aligning are the best way for principals and agents to co-ordinate and deliver tasks. If the incentives don't match, the job won't get done. Charlie Munger has a story on the power of incentives in his speech "The Psychology of Human Misjudgment":

"FedEx could not figure out how to get the night-shift workers to move packages as quickly as was necessary from one airplane to another overnight.

The speed of transfer was integral to the success of their delivery business, and it just wasn’t fast enough. They tried a few solutions, before realizing that the night crew was paid by the hour. They were being incentivized to work more hours, not fewer.

So, the management team switched the compensation from hourly to a fixed shift rate, with a rule that the workers could go home when the job was done. The workers would now get paid the same rate no matter how long it took to get the planes loaded.

Can you guess what happened?

Of course, the employees moved as quickly as possible to complete the job so they could go home. Transfer times improved, and the solution was a success."

If we apply incentives of agents and principals today, we get other stories like:

All this to say, pay attention to the power of incentives when it comes to the nature of the word, how we relate to the world, and what proportion of it we make up. I imagine it'll come in handy with your finance decisions this year. I'll explain how in this next essay, stay tuned till then.

-rushil