The Principal-Agent Problem occurs when a person (the principal) hires someone else (the agent) to act for them, but the agent may not always act in the principal’s best interest due to differing information or motives. Solutions involve creating better incentives and transparency.
The principal is the party that initiates the relationship and sets the terms that the agent should act upon. They often provide the necessary resources and require the agent to perform a certain action on their behalf. For example, shareholders in a company, patients in a healthcare context, or a government body outsourcing a public project.
The agent is the person or entity hired or chosen by the principal to perform a task or make decisions on their behalf. For example, this can be the management in a company, the doctor in a healthcare context, or a private company executing a public project.
A contract or agreement between the principal and the agent outlines the tasks the agent is expected to perform. It can be formal (legal agreement) or informal (social or moral obligations).
These costs emerge from the conflicts of interest between the principal and agent. They include monitoring costs (expenses related to overseeing the agent’s activities), bonding costs (expenses from the agent promising not to act against the principal’s interest), and residual loss (the remaining loss after investing in monitoring and bonding).
This is a situation where the agent has more or better information than the principal. This disparity can lead to two main problems: adverse selection (before the contract is signed, the principal cannot distinguish between high-quality and low-quality agents) and moral hazard (after the contract is signed, the agent may not work as hard as they promise or take undue risks).
Designing the right incentives is one method to align the interests of the principal and agent. These incentives can take the form of financial rewards, performance-based pay, or penalties for poor performance.
The principal and agent may have different attitudes towards risk, influencing their actions and decisions. A risk-averse agent might not want to take on as much risk as a risk-neutral or risk-loving principal would prefer.
Solutions to the Principal-Agent Problem
Some common solutions include monitoring, the use of incentives, reducing information asymmetry (by sharing more information or improving transparency), implementing stringent legal obligations, or improving the alignment between the principal and agent’s goals.