What is the Principal-Agent Problem?

Defining the principal-agent problem

In economics, the principal-agent problem occurs when a principal (i.e., the owner of a resource) delegates a task, service or decision to an agent and a conflict or misalignment of interests arises between both parties. Assuming that both the principal and agent are utility maximizers, this misalignment will lead to either of them acting in their own self-interest. A solution to the problem must be found, so that both parties can harmoniously behave in their mutual best interests.

In 1976, economists Michael C. Jensen and William H. Meckling created the most influential formulation of the principal-agent problem in their paper “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” In economics, this problem falls under the study of agency theory, which is often thought to be part of broader branches of microeconomics such as game theory and incentive design. Michael C. Jensen reprinted the findings of his paper in A Theory of the Firm (2003), where he explains the foundations and principles of the principal-agent problem: 

Causes and consequences of the principal-agent problem

It is helpful to use an example to bring the principal-agent problem to life, and understand its causes and consequences. The most commonly used example in agency theory literature happens within firms and organizations across the globe. In Operational Risk Management (2021), Jasmijn Bol and Jenna M. Blanche present a clear example of a principal-agent problem where the principal is the shareholder or group of shareholders who own the firm (e.g., through the acquisition of stocks). The agent here, is the CEO or the members of the executive board who make strategic decisions on behalf of the shareholders. Bol and Blanche explain:

In this example, notice that the CEO (the agent) is taking advantage of their position in the organization to benefit from financial gains. However, their actions are not in line with the best interests of the shareholders, whose aim is to maximize the net present value of the organization. It is not uncommon to find similar examples to the one above in different areas of a business. Indeed, Bol and Blanche explain that this agency relationship does not only happen between shareholders and executive board members, but that there are many organizational layers where this problem can arise. 

Bol and Blanche continue to explain that the main cause behind the principal-agent problem is information asymmetry. This happens when one party — either the principal or the agent — has more information in the decision-making process than the other one: 

This phenomenon of asymmetric information is what causes people to act in their best self-interest, which leads to moral hazard. In economics, moral hazard refers to a situation where one party takes a risky or self-serving action knowing the other party will bear the negative consequences. It is important to note that, even though the problem can go both ways (i.e., the principal has more information than the agent and benefits from it, or vice versa) it is usually the agent who uses information asymmetry to reap the benefits in a situation. This is because, as a delegatee, the agent is familiar with the day-to-day details of the task they have been assigned to perform. This means that they will be able to collect more information on the potential actions that can be taken for their individual benefit. 

Of course, the causes behind the principal-agent problem are not limited to information asymmetry. It may also be the case that agents act for their own benefit due to a lack of motivation or incentive to perform the task that the principal is asking. Equally, it may be attributed to the personalities involved and their inherent goodwill. Indeed, recent studies indicate that people who score highly in narcissism during personality tests are more likely subject to the principal-agent problem.

These root causes, in combination or in isolation, will give rise to the principal-agent problem. Broadly speaking, the main consequence of this problem is a clear misalignment and conflict in priorities, which leads to discontent and dissatisfaction on the principal or agent’s end. In agency theory, this dissatisfaction translates to “agency costs;” the price (financial and non-financial) that either the agent, principal or both parties incur from the conflict of interests. In A Theory of the Firm (2003), Michael C. Jensen goes into depth on the specific types of agency costs that exist, with an emphasis on “residual loss” as the overarching agency cost: 

Solutions for the principal-agent problem

Despite the agency costs that arise in a principal-agent relationship, it is important to note that the principal initially delegates a task or decision to the agent because they are convinced that the benefits of doing so will outweigh the costs. Therefore, the objective of agency theory is to minimise these costs to ensure that the principal’s initial hypothesis is indeed met. This dilemma is explained by Tom Delreux and Johan Adriaensen in The Principal Agent Model and the European Union (2017): 

In other words, the objective of agency theory is to find a solution to the conflict between principal and agent, which leads to agency costs. To solve this, incentives are designed to nudge and encourage people to behave in the optimal and desirable way. Going back to our organizational example, these incentives often take the form of bonuses or promotions, which motivate agents to align their actions with the principal’s desired outcome. The American business executive and public administrator Chester Barnard lists the types of incentives that can solve the principal-agent problem in his award-winning book The Functions of the Executive (1971). 

When economists design incentives to encourage specific behaviors, they build them into contracts; shared agreements between principals and agents that ensure incentives are granted (conditional on the performance of a desired output). Indeed, as Samiran Banerjee mentions in Intermediate Economics (2021), contracts are carefully and mathematically modeled, accounting for the observable desired output and the incentive required to induce that output: 

Barnard also stresses how often material or financial incentives are ineffective to solve the principal-agent problem (which at the time were almost exclusively considered by economic theory): “even in purely commercial organizations, material incentives are so weak as to be almost negligible except when reinforced by other incentives” (1971). To solve this conundrum, other types of solutions must be put in place. For instance, in the shareholder-CEO example mentioned above, it might be optimal to gather the shareholders and executive board to discuss and realign on the objectives of the organization looking ahead.

More examples of the principal-agent problem

Throughout this article, we have focused our attention on the principal-agent problem in relation to organizations; the main focus of agency theory literature. However, there are a plethora of situations and day-to-day examples where we see this problem arising and being solved.

For example, a landlord (principal) delegates the rental of flats to a letting agency (agent). With a well-designed contract in place, the principal avoids any unintended agency costs such as the agent benefiting from exorbitantly high margins, or following unstandardized and biased criteria when choosing tenants.

The principal-agent problem can be extrapolated beyond the business world too, and can be found in such areas as politics and international affairs. For example, the relationship between voters and governments can be seen as a principal-agent problem, where voters (the principals) delegate the ruling and mandate of their nation to a government (the agent). The election manifesto and votes may be interpreted as the “contract” that both parties confidently sign to enact the desired policies. 

Equally, as editors Andreas Dür and Manfred Elsig summarize, The European Union’s Foreign Economic Policies (2014) discusses how the principal-agent model behaves in the context of different international relations and affairs:

The contributors to the book choose to model international and public affairs as principal-agent relationships, because this approach takes into account the costliness and difficulty of implementing regulatory measures (or “contracts”, in principal-agent terminology) between the representatives of a principal and agent in different scenarios. As Dür and Elsig explain,

Closing thoughts

To conclude, the principal-agent problem occurs when a principal (i.e., capital or resource owner) assigns an action or task to an agent and a conflict or misalignment of priorities exists between the two. This misalignment is often caused by asymmetric information, which induces the principal or agent to use this additional information to perform a self-serving action. This produces agency costs for the disadvantaged party, which can be mitigated through the design of contracts and incentives. These incentives do not necessarily have to be of a financial nature, though these are generally thought to be the most effective. The optimal contract or incentives will vary depending on the specific principal-agent scenario — whether in business, politics, or a range of other contexts.

Further reading on Perlego

To read more about the principal-agent problem in the context of the European Union, you can read Chapter 4 of The European Union’s Foreign Economic Policies (2014), edited by Andreas Dür and Manfred Elsig 

To read more about the mathematical models behind incentive design, you can read The Theory of Incentives (2009) by Jean-Jacques Laffont and David Martimort

To read more about the principal-agent problem in the context of public policy making and foreign affairs, you can read Public Administration & Public Management: The Principal-Agent Perspective (2006) by Jan-Erik Lane

To read about the principal-agent problem in the context of sports governance, you can read The EU in International Sports Governance: A Principal-Agent Perspective on EU Control of FIFA and UEFA (2016) by Arnout Geeraert

Bibliography

Banerjee, S. (2021) Intermediate Microeconomics. 2nd edn. Taylor and Francis. Available at: https://www.perlego.com/book/2194345/intermediate-microeconomics-a-toolbuilding-approach-pdf 

Barnard, C. (1971) The Functions of the Executive. Harvard University Press. Available at: https://www.perlego.com/book/2039368/the-functions-of-the-executive-thirtieth-anniversary-edition-pdf 

Bol, J. and Blanche, J. (2021) Operational Risk Management. Business Expert Press. Available at: https://www.perlego.com/book/2497210/operational-risk-management-organizational-controls-and-incentive-system-design-pdf 

Dür, A. and Elsig, M. (eds.) (2014) The European Union’s Foreign Economic Policies. Taylor and Francis. Available at: https://www.perlego.com/book/1662676/the-european-unions-foreign-economic-policies-a-principalagent-perspective-pdf 

Delreux, T. and Adriaensen, J. (eds.) (2017) The Principal Agent Model and the European Union. Springer International Publishing. Available at: https://www.perlego.com/book/3482755/the-principal-agent-model-and-the-european-union-pdf 

Jensen, M. (2003) A Theory of the Firm. Harvard University Press. Available at: https://www.perlego.com/book/3040049/a-theory-of-the-firm-governance-residual-claims-and-organizational-forms-pdf 

External sources 

To read more about the personality traits that influence the principal-agent problem, read “The Impact of CEO Narcissism Behavior on Firm Performance through Earnings Management”