The relationship between the senior managers of a nationalised industry and government ministers can be regarded as an important example of the principal-agent relationship as outlined in Module 1. Where information about the agent's effort is very costly to gather, or where the principal is not in a position to judge the effectiveness of the agent's effort, we would normally expect the contract between principal and agent to depend, at least to some extent, on the ‘outcome’. Agents will expect to receive a greater reward if they are ‘successful’ in some defined sense than if they are unsuccessful. Any alternative contract would fall foul of the moral hazard problem (see Module 1). As the principal is unable to observe or deduce the agent's effort, the latter will have little incentive to work, except towards objectives of his own choosing.
Property rights in a public enterprise (see Section 8.2.2) are so structured, however, to make the provision of incentives difficult. This can best be illustrated by comparing a public enterprise with a joint-stock corporation. Superficially, both forms of enterprise face similar problems. Shareholders of a joint-stock company face high monitoring costs, and the managers whom they appoint to run the firm also have incentives to shirk and/or pursue their own objectives. In the eighteenth century Adam Smith took the view that agency problems would inevitably result in ‘negligence and profusion’ being associated with the joint-stock form of enterprise. More recently economists have developed ‘managerial’ models of the firm on the assumption that managers can, within limits, run joint-stock enterprises in their own interests. Closer attention to the contractual environment in the joint-stock enterprise reveals, however, that there are control mechanisms not available to public enterprise. These mechanisms derive from the existence of exchangeable rights to the profits of the enterprise.
Managers of joint-stock enterprises may receive, in addition to a basic salary, a compensation package including deferred payments such as pension rights and stock options whose value depends upon the performance of the firm. The interests of the managers are thereby brought more into line with those of the shareholders and effort incentives are provided. Incentive schemes in the public sector in which reward is linked to performance are possible, but appropriate measures of performance are extremely difficult to devise.
If managers do not pay sufficient attention to the shareholders' interests, and the flow of profits from the enterprise is therefore smaller than could be achieved if resources were efficiently managed, the market price of the company's shares will fall short of their potential value. This will create opportunities for profitable take-over raids and threaten the position of the incumbent management. The efficiency of this mechanism is open to question on the grounds that raiders may find it profitless. Existing shareholders will have an incentive to hold on to their shares rather than to tender them to a potentially successful raider at a lower price than will eventually prevail. Nevertheless, takeovers do occur, and we can expect the existence of substantial capital gains to provide encouragement to potential raiders.
Another possible constraint is provided by the managerial labour market. It is argued that a reputation for good management and attention to shareholders' interests is a valuable asset which can be traded on the labour market. Conversely, in the event of failure, the terms which can be commanded by a manager will be revised downwards. Managers of public enterprises might be influenced in a similar way, but traded shares convey information about the ‘success’ of a manager in a clear and economical form, whereas it is difficult to devise an equivalent simple mechanism for the public enterprise sector.
Managers operating in product markets where they have to compete by price and quality are forced to match the performance of their rivals and are therefore less able to ‘take it easy’. In the case of public sector enterprises the problem is that their size and natural monopoly characteristics, along with the absence of the ultimate sanction of bankruptcy, may make the product market a less effective source of discipline than is commonly experienced in other sectors.
