What is the principal-agent problem?

The principal-agent problem is the conflict of interests and priorities that arises when one person or entity, the agent, takes actions on behalf of another, the principal. The agent may act in a way that runs against the principal's best interests. The idea applies wherever an owner of an asset hands direct control over it to someone else. [1] [2]

A summary published by the CFA Institute Research Foundation says two ingredients are needed: conflicting incentives and private information. Without conflicting incentives, the principal can leave the agent alone. Without private information, the principal can write a contract that covers every possible outcome. When the principal cannot monitor the agent, the agent has both the motive and the ability to act undetected against the principal's interests. [3]

Wikipedia adds that the problem worsens as the gap in interests and information between the two grows, and when the principal lacks the means to punish the agent. The agent often holds resources such as time, information and expertise that the principal lacks. Models of the problem usually focus either on moral hazard, meaning hidden actions, or on adverse selection, meaning hidden information. [1]

Common pairings include corporate managers and shareholders, elected officials and citizens, and brokers and the buyers and sellers they serve. The Richmond Federal Reserve gives a workplace case: a firm asks a new employee to review competing supplier bids. The employee might skip the research and invent facts, or favor a supplier because of a family connection. The firm can only imperfectly watch what the employee does. [1] [4]

The CORE Economics textbook explains why contracts do not simply fix this. Employment contracts are incomplete. They cannot specify what a worker should do in every unforeseen situation, and observing every employee's effort would be impractical or too costly. Even observed effort might not be verifiable in court, and a contract cannot forbid an employee from quitting. [5]

The cost of the agent's deviation from the principal's interest is called agency cost. Investopedia describes it as including the risk that the agent shirks or decides badly, the expense of dealing with problems that follow, and the expense of creating incentives. Principals accept these costs as long as the benefits outweigh them. [2] [1]

One response is closer monitoring, but that takes significant time and resources. The Richmond Fed says the main alternative is tying pay to the performance of the firm or to a measure of productivity. CORE gives examples such as sales commission on top of a base salary, and piece-rate pay, where earnings depend entirely on what a worker produces. [4] [5]