A. Explain why this situation could be considered a principal agent problem. Who is the principal? Who is the agent?
The principal is the main proprietor of a situation. A person is said to ‘pioneer’ the situation at hand. In this case, the Bureau of Land Management (BLM) is the principle. The principle maybe unable to take the responsibility or it may be too much for him and may wish to delegate the situation to someone specialized in the situation. The one who is delegated to is called the Agent. The DBD in this case is the agent. The DBD wants to lease some land from the BLM, which is the owner of the land. In this case, the BLM is faced with a tough decision to make. The BLM wants to charge the DBD $3 million in case the DBD does not reclaim the land when it has done drilling. In this case, a problem between the two arises.
In understanding the situation at hand, we must look carefully at what a principal – agent problem is. The principal – agent problem occurs when a situation arises that motivates an agent to represent the principal in dealing with a particular situation. The BLM may be unable to meet the cost of drilling or may be too involve to drill the oil (Winch 2010, 28). This makes them delegate the whole drilling to another company. DBD, on the other hand, may be specialized in the drilling of oil and they may be the best person who can drill this.
In leasing the land by BLM to DBD the company stands to gain more than it can lose as the cost of drilling and maintenance will be passed on to DBD. Nevertheless, a problem arises where they are not sure whether DBD will reclaim the land after it is done with drilling or not. It, therefore, wants to charge DBD $3 million as money for reclaiming the land which if they do not they will spend $3 million to do it whereas DBD will spend $2 million for the reclamation of the land. The total cost of leasing the land to DBD is $5 million so they are afraid if they do not charge the $3 million, they would only make a profit of $2 million shillings. This is a business and its principle objective is to make maximum profits.
In principal – agent delegation many advantages are drawn. These include improved decision-making and the efficiency of these decisions. Decisions are wholly passed to the agent who takes the problems as their own and works to towards finding viable decisions. This means that the principal only wants a particular payoff but the rest is left to the agent. In the example of BLM and DBD, the BLM can be likened to a Landlord and the DBD as a tenant. The property owner will lease the land to the tenant and pass all that concerns to it to the tenant to manage it at a certain fee. The tenant will then make all the decisions concerning the land until the day the contract will expire (Wessels 2006, 32). This makes it easier for information to flow. Another advantage is that information asymmetric will be reduced as the DBD will be able to make their own policies and decisions without being directed monitored by the BLM. In addition, BLM by leasing the land will not be blamed for any depletion of the land that will occur. However, as a follow up activity it is making sure that by deciding to charge DBD a charge before leasing out the land will go a long way to making sure that reclamation is done once the drilling is over (Siebert 2008, 33).
This relationship may also be affected by agency losses. An agency loss is the cost incurred from the delegation from the principle to the Agent. One is slippage where the agent may be provided with the perverse incentive that may make him act contrary to the interest of the owner. In this case, the DBD may view this additional charge as a perverse incentive and this may make them not to carry out the reclamation project in the end (Faure 2009, 21). Secondly, shirking refers to the situation that the agent may want to pursue his own policy but is also limited to the interests of the owner (American Bar Association 2006, 95). In this case, the DBD may consider leasing the land and drilling the land and when it is over they can reclaim the land.
B. Draw the extensive form of this principal – agent problem and use backward induction to solve Nash equilibrium (Perea 2001, 75).
In order to draw the form we must understand backward induction and an extensive form of principal – agent problem (Ching 2003, 21).
The backward induction is a process of thinking or working things backwards. That is from the solution to the problem. Backward induction helps us to know why the present is so and what past led to present as it moves from how things are now to how they began. Backward induction can be used to calculate the decisions that one can take incase a certain problem occurs along the way to reach a particular pay off (Liu 2010, 57). Example the DBD can use the outcome they want after the drilling is over to calculate how they will operate the company and the decisions they are going to take on the way including whether to pay an extra $3 million charge or not.