Principal-Agent Problem

Updated on April 12, 2024
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Principal-Agent Problem?

The principal-agent problem showcases the conflict of priorities between two parties: a principal and their agent. The principal owns certain assets and hires an agent to make decisions on behalf of them. Conflicts arise when the agent starts to act in their own best interests instead of acting in the interests of their clients.

What Is The Principal-Agent Problem

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This creates potential losses and undesirable situations for the principal. One primary reason for this conflict is the asymmetric distribution of information between the principal and agent, i.e., the person hired to manage the assets holds more information than the asset owner, resulting in an information gap.

Key Takeaways

  • The principal-agent problem occurs when the principal hires an agent to work in their best interests, but the latter decides to act in their own self-interest, challenging the client.
  • It can cause monetary losses for the client along with operational challenges, and market failures, and diminish the trust between the two parties.
  • A real-life example can include CEOs or insurance agents catering to their own interests instead of the shareholders or clients.
  • Solutions to this problem include structuring a strong contract, incentives, and penalties through performance analysis and reducing the information gap. 

Principal Agent Problem Explained

The principal-agent problem emerges whenever there’s a conflict of interest between a person (the principal) and someone they hire to act in their interest (the agent), but the agent prioritizes their interest over their clients’. The latter emphasizes maximizing their own benefit instead of the client.

The situation was first studied in the 1970s when the economic theorists Michael Jensen and William Meckling reunited to publish a paper that discussed the structure of this concept which they called the ‘agency theory. They argued that the nature of the relationship between the owner and their contractual relationships defines the firm’s expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more.

They also discussed how information asymmetry and uncertainty cause the principal-agent problem in corporate governance. Essentially, the principal-agent is an optimal relationship where the principal delegates its authority to an agent for solving an issue. The agent decides to help the principal. The principal retains the ownership of all the assets involved in the transaction or business, but they give the agent the right to manage them, hoping to get the best result.

However, that circle breaks with a conflict of interest when the agent gets the assets and uses them on behalf of their interest instead.

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Causes

The person hiring the agent does not know whether this person will work on their behalf or not. But supposedly, they trust them. However, they are neither aware of the field or agent nor do they possess the degree of information the agent does. It makes it difficult for them to determine if the solutions and strategies implemented are in their best interest to them. As a result, the principal depends on the agent by making a leap of faith.

An agent may start to look out for their best interest for a variety of reasons. It can vary from unethical professional objectives to improper incentives or a lack of moral conduct from the principal’s side. The owner might not be sticking to the contract or earning way more than they claim to be. At the same time, they may not be compensating the agent enough. Both parties will always look after their own interests had there been no proper alignment of roles.

Conflicts of that sort are common among board membersBoard MembersBoard members comprise the individuals whom the shareholders elect as their representatives. They are responsible for taking crucial corporate decisions regarding the company's policies, dividend payouts, top-level managers' recruitment or layoff and executive compensation.read more and shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more, trusteesTrusteesA trustee is an individual or institution with legal authority to manage the trust property and assets on behalf of the settlor to benefit the beneficiary. They have complete control over the trust assets until they get transferred to the beneficiary. The administration of assets goes as per the directions of the trust. read more and beneficiaries, etc.

Effects

The principal-agent problem definition is better understood when the effects are studied well. Here, the principal inevitably faces some challenges due to the acts of self-interest by the agent. It can be monetary losses or operational challenges for the firm. The principal-agent problem in corporate governance can also cause a market failureMarket FailureMarket failure in economics is defined as a situation when a faulty allocation of resources in a market. It is triggered when there is an acute mismatch between supply and demand. As a result, prices do not match reality or when individual interests are not aligned with collective interests.read more, which is the faulty allocation of resources. Instead of using their resources most profitably, the principal will lose some of it by hiring a service that won’t provide what is needed.

It not only affects the person who is losing money because of the agent but it diminishes the overall efficiency of the whole market. In addition, the client will incur agency costsAgency CostsIt is common for shareholders' to disagree with the business manager's approach of operating business to maximize wealth. When such a situation arises, the costs incurred to resolve the conflict and restore harmony are referred to as Agency Cost.read more, which increase the costs of using that specific service and make them less attractive.

Another consequence is the erosion of trust in a certain industry. Services and people who do not deliver as promised often tarnish their reputations. It can have a huge impact on the long-term economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more of a certain industry, for example

Examples

Let us consider the following real-life principal-agent problem examples for understanding the concept better:

Example 1

A technology company decides to hire Mark as the new CEO. He is chosen for this position and the shareholders believe that he will bring value to their shares, given his market reputation and the attention he manages to get from the media.

After a few months on the job, however, the CEO discovers that it may be more profitable to act in his own interest instead of ensuring that the company is profitable. Hence, he starts focusing focus on projects that would keep him in the spotlight and maximize his own image instead of the value of the firm.

They can’t monitor what he’s doing all the time, so they may lose a lot of money until they discover that the CEO is consciously not acting in their interests.

Example 2

Another example could be seen when someone wants to buy insurance. They can’t do it alone, so they need to look for an agent. However, this agent may want to help himself more than the customer and pick a plan that gives him a higher commission, not the best service.

In this case, the person would be losing money when they could have used a better service if they had more information about the plans.

Solutions

Fortunately, there are ways to solve this problem. Let us have a look at some of the principal-agent problem solutions to know how to overcome it: 

#1 – Structuring a Strong Contract

A strong contractual agreement is necessary to pay groundwork for seamless business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.read more. The contract must be detailed, thorough, and inclusive of incentives, performance evaluation, and compensation. It should also list procedures to oversee all regulatory measures. 

#2 – Evaluating the Performance

One can create mechanisms that will evaluate agents’ performance based on their decisions. If the agents do well following these criteria, they will receive a reward. However, if it’s clear that the agents are acting only in self-interest, they may get sanctions. Periodical performance evaluations, for instance, are excellent solutions.

For example, shareholders can write a contract in which the CEO that they’re hiring will be rewarded for acting in a way that benefits them, such as making the price of the shares go up. Similarly, the contract could have some clauses which would affect the CEO negatively if it’s proven that he’s working against the shareholders. However, to prove this, they would still need to know how their work is going, which is not always possible, so the reward for good behavior is still important.

#3 – Increasing Awareness

Another solution to this problem is increasing awareness about the responsibilities and services provided by the agent. The problem is caused by asymmetric informationAsymmetric InformationAsymmetric information is the knowledge mismatch that happens when one party secures more information about a product or service than the other party to the transaction. The information failure is often seen when the seller is more informed about a product's condition than the buyer.read more, so both sides need to be well informed. By raising awareness about the work of the agent and the field in which this person works, one will effectively be creating an environment in which it’s harder for the agent to get away with this kind of behavior.

Frequently Asked Questions (FAQs)

What is the principal-agent problem?

The principal-agent problem arises when there is a conflict of interest between the owner (principal) and the person hired to manage their assets(agent). The agent, who holds more information about asset management, can make decisions that benefit him at the expense of the principal’s welfare.

How to solve a principal-agent problem?

It can be solved by proper performance evaluation, allotting adequate incentives and penalties, and fixing information asymmetry.

What is a principal-agent problem as it relates to managers and stockholders?

Stockholders enlist the best managers to do the job but may not be willing to pay them adequate wages and benefits as this decreases the shareholders’ income. The managers who are often more familiar with the field than stockholders may take decisions that reward them solely. Managers and stockholders should align their goals toward the welfare of both parties for the successful running of cooperation.

This has been a guide to what is the principal-agent problem. Here we explain the concept with real-life examples, solutions, causes, and effects. You may learn more about financing from the following articles –