What is a Principal-Agent Problem?
A principal-agent problem is when there is a conflict of interest between the agent and the principal, which typically occurs when the agent acts solely in his/her own interests. In a principal-agent relationship, the principal is the party that legally appoints the agent to make decisions and take actions on its behalf. This type of framework is used to model human behavior and how it affects the finance body of knowledge. To learn more about similar topics you can take CFI’s behavioral finance fundamentals course, which explores the fundamental issues of psychology on the behavior of financial agents.
The separation of the “ownership” (principal) and the “control” (agent) in principal-agent relationships creates the grounds for the conflict of interests between the two parties.
Reasons Behind Principal-Agent Problems
The main reasons for the principal-agent problem are conflicts of interests between two parties and the asymmetric information between them (agents tend to possess more information than principals). The principal-agent problem generally results in agency costs that the principal should bear. Because agents can act in their interests at the principals’ expense, the principle-agent problem is an example of a moral hazard.
The principle-agent problem was conceptualized in 1976 by American economists Michael Jensen and William Meckling.
The principal-agent problem has applications in political science and economics. The problem is especially significant in the understanding of corporate governance.
Examples of Principal-Agent Problem
The following cases are the most common illustrations of the principal-agent problem:
- Shareholders (principle) vs. management (agent)
- Voters (principle) vs. politicians (agent)
- Financial institutions (principle) vs. rating agencies (agent)
Solutions to Principal-Agent Problems
Solutions to the principal-agent problem aim to align the interest of both parties. There are two main areas of improvement to address the problem:
#1. Contract design
The main purpose of contract design is the creation of a contract framework between the principal and the agent to address issues of information asymmetry, stimulate the agent’s incentives to act in the interests of the principle, and determine monitoring procedures.
#2. Performance evaluation and compensation
The agent’s compensation is the primary method of aligning the interests of both parties. In order to address the principal-agent problem, the compensation must be linked to the performance of the agent.
The performance of the agent is measured by subjective evaluation because it is a more flexible and balanced assessment of complex jobs. The most common methods of agents’ compensation include stock options, profit-sharing, and deferred compensation. Nevertheless, these types of compensations alone are not the panacea for the principle-agent problem.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: