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Principal-Agent Problem

The principal-agent problem occurs when an agent acts contrary to the best interests of the principal, leading to agency costs. This conflict can arise in various relationships, such as between shareholders and CEOs, and can be addressed through contract design, performance evaluation, and aligning incentives. Solutions involve creating incentives for the agent to act in the principal's interest, such as linking compensation to performance.

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34 views6 pages

Principal-Agent Problem

The principal-agent problem occurs when an agent acts contrary to the best interests of the principal, leading to agency costs. This conflict can arise in various relationships, such as between shareholders and CEOs, and can be addressed through contract design, performance evaluation, and aligning incentives. Solutions involve creating incentives for the agent to act in the principal's interest, such as linking compensation to performance.

Uploaded by

adwanivarun22
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Principal-Agent Problem Causes,

Solutions, and Examples Explained

Investopedia / Sabrina Jiang

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.

Key Takeaways
 The principal-agent problem is a conflict in priorities between the
owner of an asset and the person to whom control of the asset has
been delegated.
 The problem can occur in many situations, from the relationship
between a client and a lawyer to the relationship between
stockholders and a CEO.
 The risk that the agent will act in a way that is contrary to the
principal’s best interest can be defined as agency costs.
 Resolving a principal-agent problem may require changing the
system of rewards in order to align priorities or improving the flow of
information, or both.

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.1

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.
Getty Images, Sabrina Jiang.

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.

What Is a Principal-Agent Problem Example?


A common example of the principal-agent problem is that of C-level
managers and shareholders. C-level managers may make decisions in
their best interest that are not in the best interest of shareholders. This
could involve enacting certain policies, making deals with politicians, and
so on, that may hurt the company but benefit the manager. Tying the C-
level manager's compensation to the performance of the company would
be a way to overcome this conflict.

What Causes the Principal-Agent Problem?


The primary cause of the principal-agent problem is agency costs. These
costs arise due to the inability of the principal to constantly monitor the
work of the agent, which could result in the agent avoiding responsibilities,
making poor decisions, or acting in a way contrary to the benefit of the
principal.

What Is a Good Way to Overcome the Principal-


Agent Problem?
A good way to overcome the principal-agent problem is by aligning the
interests of both the principal and the agent and removing any conflict of
interest. One of the best ways to do this is by aligning the compensation of
the agent to a performance evaluation. If the agent performs well, they will
see a direct financial benefit; if they perform poorly, the opposite will be
true. Methods to achieve a link between performance and compensation
are stock options, deferred-compensation plans, and profit sharing.

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.

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