What is a Principal-Agent Problem?
A principal-agent problem arises 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.
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 potential 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 principal-agent problem is an example of a moral hazard.
The principal-agent problem was conceptualized in 1976 by American economists, Michael Jensen and William Meckling.
The problem has applications in political science and in economics. It is especially significant in the understanding of corporate governance.
Examples of Principal-Agent Problem
The following cases are among the most common examples of the principal-agent problem:
- Shareholders (principal) vs. management (agent)
- Voters (principal) vs. politicians (agent)
- Financial institutions (principal) vs. rating agencies (agent)
Solutions to the Problem
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 best interests of the principal, and to determine procedures for monitoring agents.
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 usually measured by subjective evaluation because it is a more flexible and balanced assessment method for complex jobs. Common methods of agent compensation include stock options, profit-sharing, and deferred compensation. Tying the agent’s compensation closely to the benefits obtained for the principal helps to eliminate conflicts of interest.
Thank you for reading CFI’s guide on Principal-Agent Problem. To keep learning and advancing your career, the additional CFI resources below will be useful: