The Political Principal/Agent Problem

If business is to address its conflicts with an expanding government, it must ensure that its external relations departments are well managed. To do so, corporate managers must manage the border conflicts within the firm. Specifically, they need to overcome the principal/agent (P/A) problem, which for too long has exposed business to political predation. Let me explain.

The principal—the CEO—must resolve the tensions between the organizational goals and the incentives of the various subgroups within the firm, coordinating the various activities of his employees—the agents—to ensure sustainable profitability. Good managers craft incentives, directives, and an organizational culture to ensure this result.

The classic example of the P/A problem within a firm occurs between the marketing and production departments.  The marketing department may well seek a product variety to maximize sales, while the production department may favor product uniformity to reduce setup costs—both worthwhile goals that must be reconciled.

The CEO can address such internal conflicts by making explicit rules, adjusting the rewards of the departments, or allowing them to bargain. Effective managers devise an array of techniques to align the inherent biases of their subunits to achieve overall profitability. Management and MBA training programs teach business students how to employ these skills within the firm.

However, addressing this problem in the political sphere is much more difficult. Today, as government policies increasingly affect the bottom line, meeting that challenge is crucial. The skills needed to negotiate the regulatory state are complex and not easily acquired.

Not surprisingly, firms often recruit personnel to handle this task from the same government agencies or congressional committees that create and oversee these laws. Those individuals are often unfamiliar with the activities or culture of the firm.

Government affairs units within most firms actually benefit from greater government intervention in the economy. They have grown steadily as government regulations have increased. Thus, while such agents will seek to reduce the costs of new regulatory programs to their firm, they have no direct interest in the repeal of such policies.

That point was underscored by a reaction I got to a pro-economic liberalization talk I gave to a corporate environmental law group. “Interesting talk, but you know, Fred, you’re talking to the wrong group. Everyone in this room benefits from the expansion of environmental regulations.”

Moreover, corporate government affairs officers are likely to retain cultural links to their former colleagues. They also regularly engage with groups—NGOs, regulators, legislators—that have even less sympathy for the firm—or the market generally.

As a result, the firm’s  government affairs subunit managers can easily succumb to the temptation to “go native.” Retaining their old biases, they may defend their employer, but are less likely to frame that defense in moral or public interest grounds.

Too often, business representatives are the first to apologize for the perceived transgressions of their firm or sector, in the hopes of gaining peer approval. They may take positions that are consistent with the incentives they face, but that prove detrimental to the firm.

The incentives motivating those managing such political affairs sub-units can be counterproductive to the overall profitability of the firm. The challenge of management is to find ways to adjust those natural biases to improve overall performance.

Unfortunately, business managers are uncomfortable in the political sphere. Thus, they delegate decision making power to government affairs managers to a greater extent than in other areas of the company’s operations.

Business literature scarcely touches this topic. The managers of these departments often presume that they represent the moral conscience of the firm, concerned with values rather than money. Under the rubric of feel-good terms such as “corporate social responsibility,” “environmental stewardship,” or “diversity,” they pursue efforts that contribute nothing to the firm’s profitability. Yet wealth creation and innovation are also moral concerns.

Integrating the external relation functions into corporate culture poses a unique challenge. The principal must apply the positive-sum values of the private sphere to address problems that arise in the zero-sum wealth (and power) redistribution world of the political sphere.

As more power becomes concentrated in Washington, business leaders need to reinforce the moral and intellectual legitimacy of markets with greater urgency than ever before. If they fail in this effort, the open and competitive economy—on which business prosperity ultimately rests—will gradually erode.

To strengthen public support for the market on which they depend, businesses must address their political principal/agent problem. Department managers must learn how their decisions impact the core profitability of the firm. Agents and principals alike must resist the seductive nature of the political process.  Incentives for agents to direct corporate resources to activities not directly relevant to the profitability of the firm should be charted carefully.

If business fails this test, it will continue to steadily shift power from the wealth-producing elements of the market to the wealth-redistributing elements of politics. That would mean not only less productive firms, but a poorer world, too. Business has the capacity to meet this challenge. It should not hesitate.