Principal-Agent Problem Causes, Solutions, and Examples Explained

What Is the Principal-Agent Problem?

The principal-agent problem is a conflict in priorities between a person or group and the representative authorized to act on their behalf. An agent may act in a way that is contrary to the best interests of the principal.

The principal-agent problem is as varied as the possible roles of a principal and agent. It can occur in any situation in which the ownership of an asset, or a principal, delegates direct control over that asset to another party, or agent.

Understanding the Principal-Agent Problem

The principal-agent problem has become a standard factor in political science and economics. The theory was developed in the 1970s by Michael Jensen of Harvard Business School and William Meckling of the University of Rochester. In a paper published in 1976, they outlined a theory of an ownership structure designed to avoid what they defined as agency cost and its cause, which they identified as the separation of ownership and control.

This separation of control occurs when a principal hires an agent. The principal delegates a degree of control and the right to make decisions to the agent. But the principal retains ownership of the assets and the liability for any losses.

For example, a company's stock investors, as part-owners, are principals who rely on the company's chief executive officer (CEO) as their agent to carry out a strategy in their best interests. That is, they want the stock to increase in price or pay a dividend, or both. If the CEO opts instead to plow all the profits into expansion or pay big bonuses to managers, the principals may feel they have been let down by their agent.

There are a number of remedies for the principal-agent problem, and many of them involve clarifying expectations and monitoring results. The principal is generally the only party who can or will correct the problem.

What Causes the Principal-Agent Problem?

Agency Costs

Logically, the principal cannot constantly monitor the agent’s actions. The risk that the agent will shirk a responsibility, make a poor decision, or otherwise act in a way that is contrary to the principal’s best interest can be defined as agency costs. Additional agency costs can be incurred while dealing with problems that arise from an agent's actions. Agency costs are viewed as a part of transaction costs.

Agency costs may also include the expenses of setting up financial or other incentives to encourage the agent to act in a particular way. Principals are willing to bear these additional costs as long as the expected increase in the return on the investment from hiring the agent is greater than the cost of hiring the agent, including the agency costs.

Solutions to the Principal-Agent Problem

There are ways to resolve the principal-agent problem. The onus is on the principal to create incentives for the agent to act as the principal wants. Consider the first example, the relationship between shareholders and a CEO.

Contract Design

The shareholders can take action before and after hiring a manager to overcome some risks. First, they can write the manager's contract in a way that aligns the incentives of the manager with the incentives of the shareholders. The principals can require the agent to regularly report results to them. They can hire outside monitors or auditors to track information. In the worst case, they can replace the manager.

Designing a contract involves linking the interests of the principal and agent by tackling issues such as misaligned information, setting methods to monitor the agents, and incentivizing the agent to act in the best way possible for the principal.

Performance Evaluation and Compensation

Compensation is always a motivating factor and a high priority for an agent. Linking compensation to certain criteria, such as a performance evaluation, can ensure that the agent performs at a high level if their compensation depends on it. This is almost a surefire way to align the interests of both the principal and the agent.

Methods of agent compensation include stock options, deferred-compensation plans, and profit-sharing. In these methods, if the agent performs well, they will see a direct benefit; if they do not, they will be hurt financially.

At its root, it's the same principle as tipping for good service. Theoretically, tipping aligns the interests of the customer-the principal, and the agent- the waiter. Their priorities are now aligned and are focused on good service.

Examples of the Principal-Agent Problem

The principal-agent problem can crop up in many day-to-day situations beyond the financial world.

• A client who hires a lawyer may worry that the lawyer will wrack up more billable hours than are necessary.
• A homeowner may disapprove of the City Council's use of taxpayer funds.
• A home buyer may suspect that a realtor is more interested in a commission than in the buyer's concerns.

In all of these cases, the principal has little choice in the matter. An agent is necessary to get the job done.

The Bottom Line

The principal-agent problem is a conflict that arises between an individual or group and the individual charged with representing them, due to agency costs, whereby the agent avoids responsibilities, makes poor decisions, or otherwise engages in actions that work against the benefit of the individual they represent.

To remedy the agent-principal problem, the principal must take action to create an environment or incentives that would motivate the agent to work in the best interest of the principal. When engaging any representative on your behalf, it's important to be aware of the principal-agent problem to ensure you are getting the best service possible.