The notion of agency costs in economics is somewhat different from how lawyers tend to define it. It has two components – moral hazard and adverse selection.
Moral hazard is the risk that a party to a transaction will act in its own interest at the expense of the other transacting party. Moral hazard arises when a transacting party believes that its actions will not be fully detected by the other party to the transaction, and that it will benefit more than the other transacting party or will share with other party the loss arising from its own actions.
In its simplest form, moral hazard is the risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information, or has an incentive to attempt to benefit unduly before the contract expires. Adverse selection, on the other hand, is the risk of choosing a wrong party to a contract, owing to a party’s limited knowledge about the other party.
In a country like Pakistan where property rights are ill-defined and poorly protected, the agency costs make it extremely difficult to do business. The cost of doing business in Pakistan is excessively high.
For example, Pakistan stands 107th in terms of doing business, amongst 157 countries of the world covered by the World Bank. In terms of enforcing contracts, there are only two other countries behind Pakistan.
Consequently, there are not very many businesses with normal profits. Normal profit in economic theory is associated with a perfectly competitive market, wherein all factors of production (including entrepreneurship) are rewarded in accordance with their marginal contribution to the production process.
In Pakistan, most businesses are either economically in loss, and others are earning abnormal profits. Economic loss refers to a situation whereby entrepreneurs get a return less than their marginal contribution to the production process.
An abnormal profit arises when entrepreneurs earn profit proportionally higher than their marginal contribution to the production process. This situation accentuates economic disparities – the rich are fast becoming richer and the poor are even more mired in poverty. Such a situation is not sustainable though.
Moral hazard on part of employees is a huge problem in doing business in Pakistan. For fixed wage employment contracts, monitoring costs are prohibitively high. Pure incentive-based employment contracts are not popular among workers.
To make things worse, the Bonded Labour System (Abolition) Act 1992 and Bonded Labour System (Abolition) Rules 1995 and other recent labour laws make it extremely difficult for employers to devise mechanisms to ensure that employees stick to the terms of their contracts.
Prior to the above legislation, employers used to retain part of the wages paid or pay wages in advance (in the form of credit) as an enforcement mechanism to ensure that their workforce remained loyal to them. The current legislation makes these practices illegal and a further source of moral hazard on part of employees.
Consequently, the employers have either to live with an under-performing labour force or face the challenge of retaining good employees. Needless to say that this article does not endorse bonded labour at all, it merely argues that some legislation that may otherwise serve other purposes has in fact been not helpful in reducing agency costs in Pakistan.
Adverse selection makes it extremely difficult for employers to find productive employees. Due to a high number of universities and other institutions of higher learning, increasing numbers of qualified graduates enter the labour force on a regular basis.
However, there is a huge quality differential amongst these individuals. On top of that, fake degrees have added to the uncertainty facing employers about the real quality of the labour force. The reference system also does not work, as a prospective employee can easily produce excellent references from his previous employers, many of whom may in fact also be fictitious. This adds significantly to the costs of recruitment.
One may argue that employing interns on a regular basis is a possible solution to finding candidates with the right kind of credentials and attitude. Training the right interns for full-time jobs may be a source for a good labour force. However, this works only if the interns turn out to be loyal to their employers. Retaining good interns is itself a challenge.
Inducing moral behaviour amongst the labour force is a better solution. Those employers who treat their employees fairly and generously tend to benefit from their loyalty.
Many small businesses create a religious working environment for their employees as part of developing personnel imbued with honesty, loyalty and required sense of duty.
In the context of banking and finance, there is anecdotal evidence that the employees of Islamic banks and Islamic branches of conventional banks are more loyal, less immobile and more productive as compared to their conventional counterparts. Studying this rather limited phenomenon can provide insights that will help develop a moral, loyal and productive labour force in Pakistan.
The writer is an economist and a PhD from Cambridge University
Published in The Express Tribune, October 7th, 2013.
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