An Explanation Of North's Principle Agent Problem

In Institutions, Institutional Change and Economic Performance, North discusses the Principle Agent Problem where, with more information, a seller can make better-informed decisions that will inadvertently or otherwise impact a buyer who remains partially, if not entirely, ignorant. In order to combat this advantage for the seller, the buyer must depend upon institutions in order to level the playing field, therein balancing the asymmetry of knowledge that caused the Principle Agent Problem to begin with. With this in mind, North fails to recognize that depending on institutions requires a large amount of trust, which only can develop after an initial leap of faith.
To illustrate the Principle Agent Problem, North gives the example of a buyer
and seller of a house. He states that ultimately, the price of the house will be “influenced by such specific-to-the-contract factors as asymmetric information about the condition of the house (known to the seller) and the financial condition of the buyer (known to the buyer)” (North, 62). In this scenario, ultimately the seller has the advantage as he not only has a greater amount of information than the buyer, he also decides the rules of the transaction. In other words, “in the seller’s utility are the price, terms, and security of the contractual obligation, that is, the likelihood that the buyer will live up to the contract ex post” whereas the buyer is concerned with “price and credit terms but also of the attributes that are transferred with the sale” (North, 62).
There are ways to minimize the asymmetric information between buyer and seller to eliminate the Principle Agent Problem. In the aforementioned example with the transaction of a house, the buyer may hire infrastructure specialists to gage whether the seller’s price is fair. Yet, in doing so, the seller is once again in the clutches of the Principle Agent Problem—if he hires an infrastructure specialist, once again there is a distinct inequality of knowledge between the specialist and the buyer.
At this point, the buyer must take a leap of faith to trust that the specialist is knowledgeable and capable of doing his job.
His only other option is to continue perpetuating the Principle Agent Problem through means of infinite regress: The buyer may question the specialists credentials, then he my question the accountability of the credential agency, then he may question the authority of those individuals judging accountability, and so on and so forth. During no point during the infinite regression will the home buyer have the asymmetry of information be in his favor; therefore, he will never be satisfied, unless he first takes a leap of faith and decides to trust the infrastructure specialist.
Regardless of whether such a leap of faith is rational or irrational, it is a crucial part of the trust-building process. In the case of the home buyer and infrastructure specialist, who is to say whether the buyer will trust the specialist after one consultation meeting? After two meetings? After reading positive reviews on a website such as Yelp? After seeing a certificate of credentials from a specific agency? It is impossible to tell with 100% certainty when trust is established. The process is difficult and differs for everyone, but luckily is made easier through the existence of
institutions.
As a “set of rules and norms infused with power,” institutions are used to ease the transaction process between buyers and sellers by helping to establish trust. Trust in institutions is based on several factors, including but not limited to, “past history, shared interests, reputation, and transparency” (Class Notes, February 7, 2017). North argues that “people’s perceptions” of trust in an institution are crucial (North, 76). If people perceive “that the structure of rules of the system [institution] is fair and just, [there are] reduce costs” (North, 76). If they perceive “that the system is unjust, [it] raises the costs of contracting (given the costliness of measurement and enforcement of contracts)” (North, 76). Thus, without trust in institutions, transactions become more difficult.
The issue of trust in institutions is especially pertinent today considering the trust, or lack there of, American citizens have in the institution of our government.
In 1958, the American National Election Study found that 73% of people said that they could trust the government (Fingerhut). In 2015, only 19% of people reported that they trusted the government (Fingerhut). Such a stark difference in the level of trust may be due to the perceived lack of transparency of the government or even the perception that the government does not share common interests with the public.
Regardless of the reason why the public does not trust the government, the lack of trust has certainly taken a toll on the state of the nation. The public is less likely to participate in voting, retains a general resentment for the governing body, and is less inclined to inform themselves about current issues, perpetuating the asymmetry of information available for government officials and public
citizens.
So how can the Principle Agent Problem be solved? There is no fast and easy answer, especially since trust can be broken down so much faster than it may be built up. That is why having faith in others is critical in establishing relationships, be they between a buyer and seller or a government officer and a constituent. That is not to say that a buyer should put his blind faith in any odd person who offers to sell him any old house; rather, that in a world of cynics, people should be more willing to take a leap of faith and build trust in others. In doing so, people will be able to develop mutually beneficial relationships and gain more information, therein combating the Principle Agent problem by significantly reducing the asymmetry of information available to the public.