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When economists think about agency problems they typically describe cases where there are clearly identified “principals” (those whose plans we hope to be executing) and “agents” (those who typically are responsible for executing the plans).  The point we make about “principal-agent” problems is that when we drive a wedge between who the decision-maker is and the outcome being sought, the push and pull of people responding to incentives is likely to lead to outcomes that all parties would be better off had they not occurred.

Contrast two different ways to purchase beer. The first and most common way is that I go to the pub myself with my own money to purchase beer for myself. The other way is for me to ask my wife to buy beer on my behalf, using my money with perhaps me paying her a little to make the trip worthwhile for her. This is a miniaturized version of the social knowledge problem that Hayek articulated as the challenge of central planning of entire economies. In this scenario, my wife has at best a decent understanding of what I want and need, and the incentives she faces do not necessarily align with mine (she may want merely to be done as quickly as possible with the errand). My wife, who knows me better than I know myself at times, still has trouble making these decisions. What if they are out of the Sierra Nevada Torpedo? Would I prefer another IPA or would I prefer a different brew from Sierra Nevada? What if there is a better beer than the Torpedo that happens to be on sale today? And so on.

You can imagine that my wife and I can solve our problem with an informal contract, after all, our goals are clear and shared (perhaps even enhanced by the correct purchase of some good beer! … true marital bliss) so she and I do not really have a social crisis on our hand. After all, if our arrangement fell apart, we’d each easily find other ways to get what we want and rather easily I propose.

In truly commercial settings the incentives facing agents are in far more tension than with the incentives facing principles than in our private lives. Take a simple case of shirking as a teacher. Imagine my boss cares about me enabling students to invert a matrix of numbers. I wrote notes on this five years ago and have not thought about them since. I just go into class today and read them verbatim. No stories. No illustrations. No clever applications. Nothing.

In the day leading up to class, I go to the gym, take a long lunch, sit in on a seminar (collegiality), read the paper for an hour, flip through the Economist, check my e-mails, sign a few forms, but I don’t look at my notes. Knowing this, and also knowing that my boos cannot monitor whether I am making an effort, he installs a camera in my office. But even if that camera is pointed right at me, and it shows me looking at my notes and writing things down, there’s just no way to know whether I am dreaming about my summer hiking trips or paying attention to the material.

The result is predictable. We end up pursuing costly monitoring strategies and the classes still suffer. In economics, we typically start from this observation to offer up systematic ways to structure contracts (formal or informal) that are welfare improving and incentive compatible. The classic example would be firms’ Boards of Directors paying their Executives in the form of stock options tied to the performance of the company.

Houston … we have a problem!

Economists here are sliding in a huge assumption. We often stop here and construct all kinds of elaborate structures which could theoretically mitigate the agency problem.

But …

we execute a sort of Dues ex machina on our students. Out of nowhere we assume that principals will simply identify the problem, understand the problem, or even want to solve the problem! Maybe in many settings we can get away with making this assumption since we know that principals want to make money and also that there are competitive forces which ensure that failure to do so means they’ll soon go kaput.

But in higher education:

  1. It is not clear who the principals are
  2. It is not clear who the agents are
  3. It is not clear what any of them are trying to optimize (even if we could identify ’em)

And therefore there is no “price” to signal whether we should do more of something or less of something. Indeed, it is most certainly the case that university principals, whomever they are, are not out to maximize “profits” indeed most folks in higher education find profits dirty and morally inferior even as they take measures to maximize revenues. Indeed it is not even clear who the principals and who the agents are in the modern universities – in many regards all of the following can be thought to be one or both: students, parents, alumni, faculty, local communities, competitors, vendors, politicians, employees, and boards of directors — all of whom at one time or another are both consumers and producers of the “good” we call higher education. Indeed college Boards of Directors have their own agenda that does not always coincide with the long term interests of the University. For example, while many of us think that board members “buy” their way onto boards by making generous donations to their colleges in order to secure status for themselves, given the preponderance of finance and legal professionals on college boards one has to imagine the possibility that such “gifts” are merely downpayments for the funneling of university largesse toward their private interests. I am pretty sure that the money managers that sit on the boards of many universities are parts of companies that manage chunks of endowment money.

Are we to naively assume, as economists sometimes do, that: boards really want to solve the problems of the modern university? That boards are actually set up to do it? And know exactly what they should be maximizing? How should a college’s output be measured?

In competitive market settings, there are forces to discipline both principals and agents to get it right — they will not exist if they don’t, so there is a (Hayekian) evolutionary pressure for efficient organizational forms to emerge over time. In higher education I would argue that the opposite exists — that there are de-evolutionary pressures leading to an institutionalization of inefficiency. What are these two forces?

  1. Third party funding.  Note that I did not just restrict this to government funding (a nagging complaint I have with my friends on the right and on the classical liberal side of things). Having 3rd parties inject resources into higher education is like a stream of regular bailouts for struggling firms. So, independent of what this does to prices at universities, what these funds do is remove any chance that schools suffer from bad decisions, indeed that is the point I keep making when I lambaste things like the U of R’s solar picnic table. In fact, universities are rewarded for wasting resources. Indeed, I even worry that I am contributing to these problems when I pursue programming and educational initiatives outside of the traditional classroom settings. Now that I am funding speakers and reading groups and the like, maybe that frees up resources to hire another associate dean for the ethical treatment of baloney sandwiches.
  2. It’s not just incentives!  Economists need to be more consistent and pay better attention to the things we observe elsewhere. We push hard on “incentives matter” (and rightly so) and discussing agency problems sounds simply like we need only to “get the incentives right” to fix whatever ails us. But this is profoundly wrong. Both the New Institutionalist school and Public Choice school of economics have taught us that way more than incentives matter. The most dramatic illustration of this was the slow and painful transition the USSR and its satellites had after the fall of communism. We thought it was just a matter of stepping in and getting the incentives right in their economies. Rather, there are an enormous host of supporting norms, cultural factors, legal structures, and especially psychologies that have to support the changed incentive structure in order for reforms to succeed. I firmly believe that these are lacking in higher education and am afraid that if we offer up reforms at the margins to improve incentives (supposing that this were possible) that when such reforms ultimately fail, our ideas will be falsely burdened with the failure – much like the financial sector destruction of recent years has been the cross of capitalism today. Higher education reform is not going to come from old people with better incentives, but rather from new people with better attitudes and institutions.

To close an already lengthy post, I’d offer up two somewhat ad hoc comments on the idea of changing what happens in universities.

On diagnosing the problems in higher education: The major fiscal problems in higher education (independent of the intellectual ones) really began to emerge at the same time that US growth slowed down in the mid-1970s. So it is possible that what the problems are in higher education are tied to larger factors driving what Tyler Cowen calls the Great Stagnation.

On reform: I have a love affair with Ronald Coase. And I’d ask readers to consider a much underappreciated implication of his work. That implication? That addressing/correcting a particular problem does not imply that the problem in particular be directly addressed. For example, maybe the best way to extend US life expectancy is not to improve the medical system, or the cleanliness of hospitals, maybe it is improving the K12 school system. Similarly, maybe the way to think about reforming higher education is to institute reform pressures at both the front and back ends. Maybe improving what happens in K12 schools is the best way to improve the quality of higher education. At the same time, maybe reforming our corporatist/crony economic system would pressure schools to produce students who can survive in a truly competitive, meritocratic world rather than for the “who do you know” world that the OWS folks seem to be worried about. Similarly, outside of a few small intellectual circles, do we see popular messages in society about the value of liberty or about the virtues of western civilization and living in a free society? Maybe if those ideas were more widely and clearly articulated, the institutions of import in society would transform themselves to leverage that message.

Thinking about the problems in higher education as classic examples of agency problems has helped me think about the types of reforms I think are possible in higher education. I hope to be able to share some of those soon.

3 Responses to “Agency Problems and the Problems in Higher Education”

  1. Dan says:

    A Journal review of a book on higher ed began with a memorable anecdote from the book: a private college hired a consultant to implement some changes. The consultant asked staff and administrators “Who is your customer?” Answers included (and were limited to): the faculty, the trustees, basically everyone, and “the word customer is morally offensive.” You’re exactly right that the lines are blurry.

    I’m reading a great book on the principal-agent problem between patrons and artists in the Renaissance. It outlines the incentives facing each side and how they accommodated each other. The situation is really complicated! I’ll look forward if you ever do something of the same.

  2. Harry says:

    We never did a project for a university or any educational institution, us being a company which advertised itself for increasing output over input.

    I think the problem was finding the person who was willing to write a big check to do that.

    We never depended on getting slackers to work harder, nor was our considerable success dependent on making the product our client was selling more appealing. All we needed was a client committed to making things work better, agreement that everything was screwed up, and, most importantly, we would make his life better.

    One of my clients (RIP) was Don Lutz, who ran Natural Gas Pipeline of America, the first great pipeline built, serving Chicago. Don had a conviction about spending money wisely, a philosophical conviction that surpassed his thoughts of his career with the company. (Let the behaviorists think about that.)

    College presidents do not think this way, nor do board members, nor do the presidents of the faculty union. They will never be sold on a good project, but they are easy when it comes to making solar picnic tables, as long as it is not their own money.

  3. […] also finds that the “agency” problem in higher education reveals itself yet again, meaning that a convergence of interests from disparate stakeholders seems […]

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