What is principal-agent problem in economics?

The principal-agent problem is a name for the inherently competing priorities between an owner (the principal) and an employee (the agent). The agent rarely acts in the best interest of the principal. Instead, the agent acts in their own best interest.

Naval gives us a clear definition of the principal-agent problem: 

Julius Caesar famously said, "If you want it done, then go. And if not, then send." What he meant was, if you want it done right, then you have to go yourself and do it. When you are the principal, then you are the owner—you care, and you will do a great job. When you are the agent and you are doing it on somebody else's behalf, you can do a bad job. You just don't care. You optimize for yourself rather than for the principal's assets.

Every time a principal hires an agent, they give away a certain degree of control over the asset they own. In giving over control, the principal will either benefit from an agent who does a great job or suffer from a poor one. While the agent controls the project or asset, it's the owner who owns the outcome. The owner has skin in the game.

This is why if you're a principal - a founder, owner, manager, or boss that oversees the work done by other employees, you need to know how to delegate effectively. You need to understand the power of incentives. And how you can use incentives to align your goals with those of the agent who controls your assets.

The heart of the problem is that the principal - the person who owns that asset - will always care more about it than the person he or she hires to manage the asset. It's the law. And you need to learn how to correct for it.

Small Business Owner And Employee

Say a principal owns a small paint store. What do they care about? Revenue. They care about excellent customer service to keep customers happy and coming back for more paint. They also care about keeping their expenses low and widening their profit margins. 

The principal has an agent (employee) that works on the paint shop floor to stock shelves and answer customer questions. What does this agent care about? Making more money. So, they go to the owner and ask for a raise on their hourly rate.

The principal wants to keep expenses low (and profit margins wide), while the employee wants more money. This is the principal-agent problem.

Home Buyer And Realtor

A young couple wants to find the perfect house as first-time home buyers. So, they hire a realtor to find them their dream house. 

What do the principals (buyers) care about? Finding the perfect home within their budget.

What does the agent (realtor) care about? The commission they get from selling the most expensive home that the couple will say yes to as quickly as possible. 

Of course, the realtor does care about the happiness of the couple, but they probably care more about the commission check. This is the principal-agent problem. 

Shareholders and CEO

The principals of a publicly-traded company are the shareholders. These shareholders hire a CEO to run the business.

What do the principals care about? Boosting the stock price or getting a dividend check, so they make more money.

What does the agent care about? Well, the agent is the one who must run the business. And it's much easier to run a business when your employees, managers, and executive team are happy and working hard. 

So, the agent may decide that instead of a dividend payment to the shareholders, they will funnel profits back into the business with bonus checks and pay raises to the managers and executives. This is the principal-agent problem. 

Principal–agent problems occur when I (the "agent") make decisions on behalf of, or that impact, you (the "principal"). For example, think of your lawyer (the agent) recommending that you start what will likely be a protracted and expensive proceeding; you can’t be sure whether they’re recommending it because it’s in your best interests, their best interests, or both. All they need is a small personal stake in the outcome, and asymmetric information (where the agent has more knowledge than the principal), and you’ve got yourself a good old fashioned rodeo principal-agent problem.

Examples of principal-agent problems

In economics, moral hazard occurs when one person takes more risks because someone else bears the cost of those risks. You take out health insurance, and because someone else is responsible if you’re injured, you decide to pick up BASE jumping. There’s also adverse selection in who takes up the insurance in the first place - those more likely to need the insurance (who are already sick) are more likely to take it up.

When governments, central banks or other institutions decide to bail out lending institutions, this can encourage risky lending in the future. This happens if those that take the risks come to believe that they will not have to carry the full burden of potential losses.

If you look a little closer you’ll see that principal-agent problems crop up a lot when one person employs another. Because managers cannot have complete information of performance, good management involves aligning the interests of the employee with their performance, through potential shares, bonuses, and promotions. In the service sector, for example, managers often use tipping as a strategy to align the interests of the workers (waiters etc.) with those of the owners or managers. They have an incentive to provide good customer service (thus benefiting the company), because this makes it more likely that they will get a good tip.

Your doctor faces principal-agent problems too. In deciding what treatment you need, they also have a personal stake in some outcomes because they earn more with more treatment, and it would be between very surprising and I’m-not-sure-we’re-in-Kansas-anymore surprising if they never acted to in their own self-interest.

Definition: The principle agent problem arises when one party (agent) agrees to work in favor of another party (principle) in return for some incentives. Such an agreement may incur huge costs for the agent, thereby leading to the problems of moral hazard and conflict of interest. Owing to the costs incurred, the agent might begin to pursue his own agenda and ignore the best interest of the principle, thereby causing the principal agent problem to occur.

Description: The costs to agent and subsequent conflict of interest arise due to the skewed information symmetry and the risk of failure faced by the principal.

For example: Shareholders of a company appoint managers to look after the proceedings of the company and earn profits on their behalf. The shareholders expect the managers to distribute all the profits to the shareholders. But the managers sensing their own growth and salary expectation try to retain the profits for future as a safe side. This can lead to principle agent problem. It is one of the most noticed problems in the current situation when most companies are not being managed by the owners themselves.

The conflict of interest between the agent and the principal

A principal-agent problem arises when there is a conflict of interest between the agent and the principal, which typically occurs when the agent acts solely in his/her own interests. In a principal-agent relationship, the principal is the party that legally appoints the agent to make decisions and take actions on its behalf.

To learn more about similar topics, you can take CFI’s behavioral finance fundamentals course, which explores the fundamental issues of psychology on the behavior of financial agents.

The separation of the “ownership” (principal) and the “control” (agent) in principal-agent relationships creates the grounds for potential conflict of interests between the two parties.

Reasons Behind Principal-Agent Problems

The main reasons for the principal-agent problem are conflicts of interests between two parties and the asymmetric information between them (agents tend to possess more information than principals). The principal-agent problem generally results in agency costs that the principal should bear. Because agents can act in their interests at the principals’ expense, the principal-agent problem is an example of a moral hazard.

The principal-agent problem was conceptualized in 1976 by American economists, Michael Jensen and William Meckling.

The problem has applications in political science and in economics. It is especially significant in the understanding of corporate governance.

Examples of Principal-Agent Problem

The following cases are among the most common examples of the principal-agent problem:

• Shareholders (principal) vs. management (agent)
• Voters (principal) vs. politicians (agent)
• Financial institutions (principal) vs. rating agencies (agent)

Solutions to the Problem

Solutions to the principal-agent problem aim to align the interest of both parties. There are two main areas of improvement to address the problem:

1. Contract design

The main purpose of contract design is the creation of a contract framework between the principal and the agent to address issues of information asymmetry, stimulate the agent’s incentives to act in the best interests of the principal, and to determine procedures for monitoring agents.

2. Performance evaluation and compensation

The agent’s compensation is the primary method of aligning the interests of both parties. In order to address the principal-agent problem, the compensation must be linked to the performance of the agent.

The performance of the agent is usually measured by subjective evaluation because it is a more flexible and balanced assessment method for complex jobs. Common methods of agent compensation include stock options, profit-sharing, and deferred compensation. Tying the agent’s compensation closely to the benefits obtained for the principal helps to eliminate conflicts of interest.

Related Readings

Thank you for reading CFI’s guide on Principal-Agent Problem. To keep learning and advancing your career, the additional CFI resources below will be useful: