According to Investopedia, “The principal-agent problem develops when a principal creates an environment in which an agent's incentives don't align with its own.” This specific example of moral hazard results from differing interests and information asymmetries.
Why do economic development efforts often fail fantastically?
You guessed it. The principal-agent problem. Here are five ways that the principal-agent problem kills economic development efforts:
1. Voters and Elected Officials
Once elected officials enter office, they do not need to fulfill their campaign promises. Even if they are up for re-election, it may be in their best interest to appease major campaign donors, rather than individual voters. Since legislation is often too long and complex for voters to bother reading, public perceptions of elected officials are often crafted by the media. This information asymmetry often results in economic development initiatives that are merely for show. The situation gets even worse if bribes and backroom deals occur.
2. Elected Officials and Regulators
Regulators know the industries that they regulate much more intimately than elected officials do. Almost all regulators desire to keep their government jobs or jump to a more lucrative careers in the private sector. Either way, regulators possess incentives to take credit for successes and conceal their mistakes, using information asymmetries to keep elected officials and supervisors content. When regulators want to use the revolving door to enter the private sector, they can use information asymmetries to their advantage to appease private-sector interests at the expense of politicians.
3. Regulators and Businesses
Although regulators understand industries, businesses know their operations better than outsiders. Attempting to maximize shareholder value, businesses may bend or break regulations. Depending on the reasons for pursuing economic development, regulators and entrepreneurs can end up at odds. For example, generating taxable revenue and increasing employment may not serve shareholder interests. Offshore holdings and automation may benefit entrepreneurs and investors, but they may not help regulators, as well as politicians, achieve their objectives.
4. Regulators and Support Organizations
The relationship between regulators and support organizations is similar to the relationship between regulators and businesses. Support organizations understand their own operations much better than regulators. This is especially dangerous when support organizations are competing with each other for government grants. Incentivized to stay in operation and maintain their salaries, support organization personnel may exploit information asymmetries to exaggerate their economic development contributions.
5. Support Organizations and Businesses
Support organizations and businesses can ideally align their interests through contracts and equity deals. However, deals can become so complex that one side manipulates the other and, as they say on Wall Street, “rips their face off.” More commonly, one side just fails to deliver on their promises, and the situation becomes even more complex when they attempt to save face for regulators.
How Can You Solve Principal-Agent Problems?
Startup Commons offers a suite of tools that are designed to eliminate principal-agent problems in startup ecosystems. Our digital ecosystem applications increase transparency for all parties, reducing information asymmetries at all levels of economic development. What can you accomplish with trust and transparency?
Supporting startup ecosystem development, from entrepreneurship education, to consulting to digital infrastructure for connecting, measuring and international benchmarking.
Subscribe for updates
Startup ecosystem development updates with news, tips and case studies from cities around the world.
Are you interested to join our global venture to help develop startup ecosystems around the world?