What Is The Principle-Agent Problem? Principle-agent Problem In A Nutshell

The theory behind the principle-agent problem was developed by Harvard Business School Professor Michael Jensen and economist and management professor William H. Meckling. The principle-agent problem describes a conflict in priorities between a person or group and the representative authorized to make decisions on their behalf.

Understanding the principle-agent problem

In a 1976 paper titled Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Jensen and Meckling proposed an ownership structure theory to avoid what they defined as the separation of ownership and control.

This separation occurs when the interests of the agent and the principle diverge. When one person (the agent) is allowed to make decisions on behalf of another person (the principle), a conflict of interest can sometimes result. The agent may have more information than the principle, which means the principle cannot predict how the agent will act. As such, the agent tends to pursue their own goals instead of prioritizing the goals of the principle. 

This scenario is often problematic for the principle, who typically retains ownership of assets and are liable for losses incurred despite delegating some degree of control and authority to the agent.

Agency costs in the principle-agent problem

Agency costs are incurred when the interests of the agent and the principle diverge and need to be resolved. 

For example, a traveling sales executive may prefer to stay in expensive hotels or eat at fancy restaurants. In so doing, the individual is looking after their own interests while adding little value to the company or its shareholders. 

The agency cost of this behavior then decreases the financial performance of the company. In addition to paying high expense bills, the company may also incur costs from hiring an external auditor to analyze its financial statements. It may also be forced to terminate the employee in question and engage in an expensive and exhaustive recruitment process.

To that end, there are two categories of agency costs:

  1. Costs incurred by the principle (shareholder) to prevent the agent (management team) from prioritizing their needs over shareholder interests.
  2. Costs incurred by the principle (company) when the agent (management team) uses company resources for their own benefit.

How can the principle-agent problem be addressed?

The solution to the principle-agent problem revolves around aligning the interests of both parties.

Here is how this might be achieved:

  1. Contract design – or the creation of a contract framework between the principle and the agent. This ensures potential sources of information asymmetry are clearly defined, meaning the agent is less likely to act in a way that furthers their own interests. Furthermore, the contract should stipulate how the actions of the agent will be monitored to increase compliance.
  2. Performance evaluation and compensation – while monitoring is important, performance compensation provides extra motivation for the agent to act in a way that aligns with the principle’s interests. Performance should be evaluated subjectively because this is a more flexible and balanced method for complex tasks or arrangements.  Depending on the situation, the principle may offer the agent deferred compensation, stock options, or profit-sharing.

Key takeaways:

  • The principle-agent problem describes a conflict in priorities between a person or group and the representative authorized to make decisions on their behalf. It was first introduced by Michael Jensen and William H. Meckling in 1976.
  • The principle-agent problem states that when the interests of the agent and principle diverge, agency costs are incurred. These costs result when the principle tries to prevent the agent from prioritizing their needs over the needs of shareholders. Costs are also incurred when an agent misuses company funds for their own benefit without adding value to the bottom line.
  • The principle-agent problem can be rectified by smart contract design. Contracts should identify potential sources of information asymmetry and include a plan for monitoring the actions of the agent. What’s more, the agent should be financially motivated to act in a way that benefits the principle.

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