Standard Setting in an Agency

The decision to hire an agent (manager) to transact business on the principal's (owner's) behalf reflects (and results) in the agent's use of specialized skills and information in managing the agency's (firm's) activities. This paper considers an agency relationship where the principal and the agent have differing beliefs regarding the uncertain economic returns to the agency and investigates the properties of standard setting and profit sharing as an incentive device. It is demonstrated that this incentive scheme causes the agent to use, without intervention by the principal, his presumably “superior” information in a manner which is mutually beneficial to the agent and the principal. It is also demonstrated that this incentive scheme is not inferior and is usually superior to a scheme in which the principal instructs the agent on which decision to implement.