Using Different Budgeting Procedures to Coordinate Principal-Agent Relationships
23 Pages Posted: 17 Aug 1999
Date Written: July 27, 1999
Principal-Agent models consider vertical coordination problems within a firm, when there is a trade-off between efficient risk-sharing and efficient incentives to work. One reason of the agency problem is the activity set available to the agent and the principal's inability to costlessly observe the agent's action choice. Budgeting systems reduce the agent's activity set, therefore reducing the agency problem. When applying a budgeting system e.g. in an overhead cost department, the principal determines the activity set which is available to the agent. Then, the principal might either specify several activities which account for known environmental conditions. Because of the different activities we address this alternative as a flexible budget. There, the agent's task is to choose one of the given activities. Alternatively, the principal might specify fewer activities that are available to the agent, i.e. she reduces the diversity of the agent's reactions to environmental conditions. Then, a rigid budget results.
We analyze a moral hazard problem resulting from a combined hidden action and hidden information situation. The agency problem is formulated with the assumptions of the LEN-model. For several budgeting procedures we determine second best reward schedules, activity sets and levels, and show the conditions, where flexible or rigid budgeting systems are likewise to be applied to.
JEL Classification: M40, M46, D82
Suggested Citation: Suggested Citation