Risk aversion and the principal-agent problem

Bruce MacEwen, author of the ever-interesting blog, Adam Smith, Esq., reviewed an article by McKinsey and plunged into behavioral economics and decision making (Dec. 30, 2005). I recommend the entire post for those who want to understand more about decision-making by lawyers.

After recounting the propensity of people to worry more about losing money than gaining (loss aversion), he touched on the “principal-agent problem.” Let me apply this point to law departments.

The company is the principal; the agent is the general counsel; the decision is whether to take a risk on how the legal function is managed. Take your pick for that risk: outsource a chunk of work, shift work to India, choose one law firm to handle all the outside legal work, invest heavily in technology, do something dramatic and risky in a major lawsuit. Let’s assume any of those decisions costs something, but holds out even odds of saving or recouping five times as much.

The principal might leap for such good odds, but the agent fears possible losses even more. The gain would be forgotten or claimed by many; the loss would be pinned on the general counsel. Thus doth conscience make cowards of us all.

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