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Warwick MarshallID# 6599640Otago University, 2005Research ProposalWarwick MarshallDeveloping a framework for identifying a Principals ideal course of action in an environment rich in agent collusionKey terms:Collusion, Principal-Agent-Relationships, Rent Extraction, Transaction cost, Effort, Incentive, Power of Collusion, Information Powerbase and Transfer, Perceived (heuristic relative) benefit, Joint Utility, Exploitation, Symmetrical and asymmetrical Information, Stake dependence, Side-contracting, Organisational design (contracting structure and monitoring), Game theory, Nash-equilibrium, Utility, Hard/True InformationAbstractQuite simply, market places rely heavily on principal(employer)-agent(employee) relationships in order to get stuff done. The relationships involved rely on informational exchanges in order for the appropriate value of the agents services to be realised. The advantage in the evaluative process lies with whoever has the information powerbase. Multiple conditions exist within market places where agents can collude to get more from the principal (or the principal can collude with agents to get more from secondary agents). Unfortunately the actions identified to stop this collusive behaviour (which can have a negative effect on competitive advantage) can end up costing the principal more than letting the collusive behaviour continue! What the principal needs is a frame work from which to work from to identify what courses of action are the most suitable in a variety of dynamic marketplace situations so as to ensure and maintain competitive advantage by maximising the rent extracted from agents. This document is a proposal for the research into Developing a framework for identifying a Principals ideal course of action in an environment rich in agent collusionIntroductionA framework is probably best described using an analogy; it is a skeletal structure from which one can gain stability for the construction of action. With relation to the proposed topic Developing a framework for identifying a Principals ideal course of action in an environment rich in agent collusion we could draw the conclusion that the framework, that would ideally result from engagement in this research, would be the skeletal structure that a principal could use to evaluate the appropriate theoretical action that they can then translate, or construct, into practical action. The objective of such a framework is to fill a void in the commercial segment on regarding collusive action and the disutility of effort identifying the resultant effect on competitive advantage and offering conceptual unity and direction for action (particularly for risk averse principals). In other words; to help principals identify hurdles (collusion) and how to get over them, while stopping the principal racing over the hurdle just to fall in the trap (disutility of effort) on the other side.BackgroundCollusive practices are prevalent in many exchange situations. However, once we look at business contexts and introduce Resss Principal-Agent theory (1985) we can see it has serious implications for the misallocation of resources which in turn would have a negative impact on competitive advantages in marketplaces. For obvious reasons outlined in Resss work, the principal (employer) needs to employ agents (employees) because they have either; greater information and capabilities, or it is just uneconomical (or the opportunity cost is too great) for the principal to accomplish the allocated tasks themselves.Agents exert greater effort when offered incentives (Ress, 1985; Panova and Rangel, 2002) but Prospect Theory (Kahneman and Tversky 1979) identifies that in an exchange situation the individuals involved evaluate losses and gains (referenced against a relevant relative heuristics) subjectively - thus coming to different conclusions on the value of action. This is entirely dependent on the individual parties information base from which they draw, an assumedly, rational conclusion (as irrational conclusions and action may negate the exchange entirely). Because of the variations in weighting resulting from asymmetric informational bases the utility expected from the exchange varies along with the negotiation and directly affects the actual utility they receive.When agents are hired a contract is formed (the type of contract depends on the organizational structure). Getting the agent to act in the interest of the employer is enforced by the consequences of breaking the rules of the contract, but getting the agent to act in the best interest of the principal is hard to monitor and impossible to ensure . As such, incentives may need to be offered to the agents on top of contracted arrangements as, over time, effort exerted by the agents may diminish (Ress, 1985). If more than one agent is required for a task to be accomplished then, if collusion can occur, the control of information provided to, and exchanged between, the agents involved needs to be controlled by the principal as it has a bearing on the amount of effort the agents invest into completing the required task (the greater the effort exerted, the greater the probability of the task being completed successfully) (Panova and Rangel, 2002). Alternatively, if the agents are in control of the information powerbase the payment for the rent can be maximized resulting in reduced benefit (per dollar) to the principal.The effort invested by agents could possibly be transferred to other tasks but, given that the greater the effort invested the greater the likelihood of the resultant success of the operation, the principal would prefer more effort to be invested because this means that a greater amount of rent is extracted (where rent is the use extracted for a fee). The agent would prefer to accomplish the task successfully but with minimum effort. Such is the logical reason for the offering of incentives. As well as being directly relative to the information powerbase, control over the advantage that can be gained in collusion rich environments is also relative to whether or not the multitude of agents that could collude have projects that are symmetrical or asymmetrical. If they are symmetrical then the principal benefits, to a greater extent, if they can somehow prevent the agents from sharing information. Conversely, if the projects are asymmetrical the principal may or may not want the agents to share information if information sharing and collusion is desirable then the principal will need to offer additional incentives (not exceeding the resultant benefit of the incentive) to the employed agents in order to maintain high levels of effort. Unfortunately for the agents, if the information powerbase lies with the principal then the disutility of effort is likely to be in the favour of the principal also. This costs the agents more, or in other words the principal extracts greater rent for the fee incurred (Panova and Rangel, 2002).When forming contractual relationships with potentially collusive agents there are several options for monitoring behaviour in order for the appropriate rent extraction to be observed. Organisational design is proposed by Vafai (2005) as being an important factor when dealing with an environment where agents could be colluding, identifying that the common organizational hierarchy exists as principalsupervisoragent. This is commonly used because the supervisor has knowledge or capabilities that the principal does not, or in other words the supervisory monitoring function is more efficient to be delegated rather than accomplished by the principal although the same information could, technically, be available to both. The aforementioned organisational structure, although vastly common and necessary, may not be the optimal organizational structure in collusive environments because the supervisor may subvert information they do not wish to be conveyed to the principal or could conceal reality by suggesting the monitoring did not reveal the information (difficult to prove). To combat this, or to test the allegiance of the supervisor, the principal could monitor the agents in tandem with the supervisor and compare the results with what the supervisor reports but then, logically, the whole point of having the supervisor (so effort can be focussed elsewhere) becomes irrelevant. The information concealment (the heart of this particular issue) works both ways; the principal may conceal discoveries that production was greater than expected (or similar rewarding result) and the Agent may wish to conceal a disappointing result. Either way it is the monitoring-intermediary (supervising) agent that is subject to the bribery/collusion. It should be clear now that collusive action can be by the principal against agents just like it can be by the agents against the principal. As a solution both the principal and agent need incentives (from each other) to share information for maximum efficiency. Although the weakness of the principal-supervisor-agent hierarchy is identified it must be noted that its use allows the principal to extract truth from the agents without having to offer additional rent costs to each individual party. This is referred to as the information-effect of delegation (Vafai, 2005). Chart 1 illustrates the principal-supervisor-agent organisational structure. Vafai offers the concluding statement “the possibility of collusion may set a limit to the size of organizations.” (2005. p1)Chart 1.PrincipalSupervisorAgentAgentAgentAlternatively, although not strictly beneficial, the use of third party risk neutral agents can offer informed insight into multiple agent contractual arrangement collusion. Additionally they can organise collusive situations that offer seemingly optimal rent to the principal with content collusive partners (supposing that all agents accept the grand mechanism Che and Kim, 2004). The third party can act to maximise the joint utility of side payments between colluding parties. Although the risk free third party will need to be rewarded (paid) they will be free from collusive influence as the rejection of any bribery offered would likely have to be part of their standardised business practice (Che and Kim, 2004). This risk neutral third party would be of use to both colluding agents and a principal, provided they did not become collusive themselves! It is here that the dilemma for the principal becomes apparent. When trying to determine the appropriate cost of rent from agents the use of the third party may be less efficient than merely accepting the conditions of dealings with colluding parties and their side contracting, much like monitoring agents in order to identify if a supervisor is truthful defeats the purpose of the supervisor. Securing a collusion proof arrangement for principal-agent relationships is often, and for all intensive purposes should be, a goal of principal organisations when contracting out tasks or extracting rent. “The design of the organization can possibly be used to increase the transaction costs of side-contracting, to improve both individual and group incentives and by the same token to increase the firms profit.” (Faure-Grimaud et al., 2001. p1). In which case it is in the principals (firms) interest to use systems that discourages (for want of a better word) collusive side contracting of intermediary agents as this avoids the possibly inefficient ramifications (increased cost and decreased effort/likelihood of success) of collusion on competitive advantage. One could perhaps analogise this to owning an SUV and being unable to sell or trade it while someone else inflates the price of the petrol that you have to buy to run it. The question is as to whether or not the collusion-proof organization design is really collusion proof. Or referring to the SUV example: the question is whether or not a new engine will get around the control of the petrol prices. The truth seems to be, with a somewhat philosophical ring to it, that there is no truth, no collusion-proof organisational design, only circumstantial idealised courses of action.The benefits to agents when colluding is obvious; falling short of price fixing or developing an informal cartel, agents can collude with one another for mutual benefit and extract maximum payment for minimal rent. This is a value chain inefficiency; essentially a kind of information ransom from the perspective of the principal. However, by colluding, agents incur costs to one another (Quesada, 2002). For this reason not all collusive situations are beneficial to all of the agents involved because the costs may outweigh benefits (Bolton, 1991). As compensatory measure, the relative benefit of collusion is often distributed proportionately equal to the market share that each of the collusive parties had when they first entered the collusive arrangement (Roos, 2003). At first this sounds like a fool proof way for the colluding agents to gain stability and control over the market, but such static market places are the prime location to find new entrants with cleverly diversifying strategies. A new entrant to the market place may delay their inclusion to the collusive arrangement (at high cost to themselves) with the knowledge that the more market share they have before they agree the greater proportion or the benefit they will receive. This re-introduces a competitive nature into dynamic collaborative arrangements as it reminds us that each independent organisation has its own strategical goals and objectives. “Heterogeneous firms make collusion, entry, exit, and investment decisions within an evolving environment.” (Roos, 2003. pp1) As such, the need to evaluate the ideal competitive and advantageous course of action regarding collusive action for the organisation is a major strategic concern. The principal can benefit, if aware of the arrangements, by utilizing this informational advantage by favouring the excluded agent and extracting maximum rent boycotting the colluding agents if possible. The agent can benefit by forgoing immediate collusional behaviour in favour of a more timely application. Obviously these options are not always available as they are constrained by timeliness and information access (Roos, 2003).Hinging heavily on game theory, colluding agents “are assumed to devise complex conditional punishment and reward regimes to create the incentives necessary to sustain an optimal degree of collusion.” (Roos, 2003. p4). The agents need to make the incentives strong enough, or the punishment severe enough so that a multiple party Nash-equilibrium can evolve where all can benefit consistently. There is a heavy reliance on the accuracy of the information being exchanged between the colluding agents for the coordination of the collusive arrangement. One could imagine a collusive arrangement occurring within a larger collusive arrangement as one agent attempts to gain competitive advantage over the other colluding agents such is the Prisoners dilemma (the difficulty of deciding when to cooperate and when to harvest the relationship for selfish benefit). Just as the principal cannot ensure a supervising agent is acting in its best interest, colluding agents cannot be sure that their partners are honest (Vafai, 2005). And, unfortunately, the control measures and investigative techniques that can be used to improve the likelihood of best interest actions or honesty can cost more to utilise that the likely benefit of use resulting in a possible disutility of effort in attempting to reduce disutility of effort!Interestingly enough, even if the agents that a principal is confronted with are colluding to skew the cost of information/task rent, exogenous transaction comparisons can give reference for agency cost allocation and distortion (Faure-Grimaud et al., 2001). A keen eye trained on competitor cost allocation (external to the organisation) can act as an alarm bell for identifying the collusion of agents in the supply chain.If the principal is requiring the use of agents because they are the ones with the greater information powerbase then the story is different again. Competitive strength is lost when the principal is misinformed or receives biased information under the guise of being hard facts which “can be obtained only through monitoring, contracts depend on the monitors report.” (Vafai, 2005. pp20). From this we can see that if an agent agent 1 is required to do the monitoring of other agent(s) agent(s) 2, then agent(s) 2 need only collude with/bribe agent 1 in order to obtain a favourable contract. If the contract is overly favourable to the agents then it could potentially be devastating to the principal (although devastating to the point of collapse would not be in the agents interest as it still requires the price in exchange for the rent).The measuring and monitoring of the agents, in order to maximize the extraction of rent or secure favourable contractual agreements, is evidently expensive and confusing yet incredibly critical to an organisations competitive successes when agents are colluding in the market place. For this reason I feel there is significant necessity for me to engage in research with the objective of Developing a framework for identifying a Principals ideal course of action in an environment rich in agent collusionMethodologySeveral central issues need to be resolved before research into Developing a framework for identifying a Principals ideal course of action in an environment rich in agent collusion can be seriously undertaken: What defines an action as ideal? What definition of collusion am I going to use?The methodological approaches observed in the literature I have encountered so far have primarily been adopting positivist, quantitative m