#10. Principal Agent Theory
Being successful at work!
Few months back, I was meeting a couple of energetic graduates who had joined our organization, embarking on their career. During the interactive session, one of the graduates asked - “what is that one thing you would recommend us to be successful in our career”. I said, think and act like the Principal and not the Agent.
Narada vs Garuda
To bring home the point, this is the story I narrated to the graduates (read in Business Sutra book by Devdutt Pattanaik).
Lord Vishnu decides to have Garuda’s (lord Vishnu’s carrier) statue placed before his in the temples. Sage Narada, being the staunchest devotee of lord Vishnu, is upset on Garuda being chosen instead of him. Naradaji decides to confront lord Vishnu. As he starts pleading his case, there is a loud sound outside the palace. Below is the interaction that happens:
Vishnuji: Naradji could you pls go out and see what happened?
Naradji (follows as said and comes back): Vishnuji there is a milk seller, she slipped on the wet floor
Vishnuji: Oh, I hope she is not hurt...could you pls check
Naradji (goes out and checks): No she is not hurt
Vishuji: I hope she did not incur any loss...
Naradji (goes out again to evaluate):...
As this was happening, Garuda arrives at the scene and then goes to Lord Vishnu - mentioning that there is a lady who comes daily from her village in our palace to sell milk she slipped on a wet floor, she is not hurt but has her pot broken and milk spilled allover. I have compensated her for the loss and asked the guards to drop her back to her village. Cleaners have been requested to wipe out the mess.
Vishnuji now looks at Naradji, who, without any further questions/clarifications understands why Garuda has been chosen over him and returns home.
In the above story, Vishnuji is the principal, Naradji is the agent, and Garuda is the agent who acted like the principal.
Principal-Agent theory
“If you want it done, then go. And if not, then send.”
-Julius Caesar
Employer-employee, lawyer-client, buyer-supplier are some examples of principal-agent relationship. Principal is the owner who delegates the work to Agent to act on their behalf. A principal would care for the business and do their best whereas an agent would not care as much as the principal and would act in their own interests. Principal has their skin in the game whereas agent does not. Agents act in their own interests rather than in the interest of the principal with principal not having enough information to monitor the agent activities.
Lack of understanding of this problem could lead to disasters - take for example Sears Holding Corporation - 120+yr old organization - largest retailer in United States in 1980s. It was once Walmart’s main competitor. Down the line, various division leaders (agents) competed with each other in their division’s interest rather that the organization as a whole. For example, the appliance division was selling and placing non-sears product more prominently in the stores as they led to better profits - though overall organization profitability took a hit. Obviously, Sears Holding Corporation ultimately filed for bankruptcy in 2018.
“If you do not understand the principal-agent problem, you will not know how to navigate your way through the world. It is important if you want to build a successful company or be successful in your dealings.”
-Naval Ravikant
Power of Incentives
Organizations, include MBOs, ESOPS etc. in the compensation structure to have employees aligned with the organization objectives. This ensures employees incentives are same as employer’s and they act to maximize their incentives which in-turn is in the interest of the organization. Having the right incentives is the key to solving the Principal-Agent problem.
Quoting two cases on the power of incentives - as mentioned by Charlie Munger in his famous 'Psychology of Human Misjudgment' speech from 1995:
Misplaced incentives
“Early in the history of Xerox, Joe Wilson, who was then in the government, had to go back to Xerox because he couldn’t understand how their better, new machine was selling so poorly in relation to their older and inferior machine. Of course when he got there, he found out that the commission arrangement with the salesmen gave a tremendous incentive to the inferior machine.”
Power of right incentives
“The integrity of the Federal Express system requires that all packages be shifted rapidly among airplanes in one central airport each night. And the system has no integrity for the customers if the night work shift can’t accomplish its assignment fast. And Federal Express had one hell of a time getting the night shift to do the right thing. They tried moral suasion. They tried everything in the world without luck. And, finally, somebody got the happy thought that it was foolish to pay the night shift by the hour when what the employer wanted was not maximized billable hours of employee service but fault-free, rapid performance of a particular task. Maybe, this person thought, if they paid the employees per shift and let all night shift employees go home when all the planes were loaded, the system would work better. And, lo and behold, that solution worked.”
As expected, the employees moved as quickly as possible to complete the job so they could go home early. Transfer times improved, and the solution was a success at FedEx.
Being successful at work!
As an employee, the way to success is to behave like a principal. When in dilemma, think what a person with skin in the game - the principal - would do. Act like one.
This is one of the keys to a successful career and to ultimately become the principal!
References:
Blown away by the depth of it.
Loved the line “If you really want it, then go. If not, then send “