Principal-Agent Problem

Principal-Agent Problem Example

Let's get right into the principal-agent problem example:

Causes of Principal-Agent Problem

What are the causes of the principal-agent problem?

We know that, if an employee tries to pursue his/her personal goal over the firm's goal, the principal-agent problem arises. Let's take a look into how asymmetric information can cause an agent to change their behavior.

Suppose, Jack is the employee (agent) and works as a salesperson for Hannah, owner of the firm (principal). Hannah's firm sells luxury jewelry, and Jack's responsibility as an employee is to get along with the objective of profit maximization set by Hannah. Hannah must rely on Jack as his effort in driving up sales will have a direct effect on the profit of the firm. On the other hand, profit can depend on other factors, such as the quality of the product and luck.

It is very hard to monitor the effort of Jack as various factors are associated to pursue the objective of profit maximization. But as an owner of the firm, Hannah would always want her employees to pursue the goal of the firm.

Table 1 - Causes of Principal-agent Problem

The table above illustrates that Jack can either put a high effort or a low effort into his work. Keeping in mind the other factors associated with the revenue, Jack can either generate $50,000 or $80,000 in revenue by putting in a low effort. While, if he puts in the higher effort, he will be able to generate $80,000 or $100,000 depending on his luck.

Now, you must be thinking, $80,000 can be generated in both cases whether Jack puts in a low or high effort; how will the owner figure out the actual amount of effort put in by the employee? That's the exact problem with trying to measure the effort of the employee. Due to the information asymmetry, the owners are unable to figure out the actual situation whether the employee has put in a high effort or low effort.

Causes of Principal-Agent Problem: Asymmetric Information

Asymmetric information is a phenomenon when one party (seller) involved in an economic transaction possesses additional information about a product or service than the other party (buyer). The theory of asymmetric information was developed in the 1970s, and it states that the information gap between the buyer and the seller can be the possible reason for market failure in the long run. Market failure can occur as the true price of different quality products cannot be determined by the buyer. As a result, high-quality products and low-quality products, both can be sold at the same price.

Principal-Agent Problem Moral Hazard

Let's take a look into the principal-agent problem and moral hazard.

When the agent knows that they cannot be observed and alters their behavior at the expense of the principal, this is an example of a moral hazard. The major cause of moral hazard is the asymmetric information between the principal and the agent.

Moral hazard does not only alter the behavior of the agent, but it might also lead to market inefficiency.

Principal-Agent Problem Solution Approach

What would be the solution approach to the principal-agent problem? We know that information asymmetry is a key factor contributing to the principal-agent problem. When assessing prospective solutions, it is essential to take the objectives of the agent and the principal into account.

Let's access some of the payment schemes that will be able to effectively solve the principal-agent problem.

• Solutions to principal-agent problems
  • Revenue-sharing structure
  • Long-term contracts

Principal-Agent Problem Solution Approach: Revenue-Sharing Structure

One of the possible solutions to the principal-agent problem is by introducing a revenue-sharing structure with the employees of the firm. The revenue-sharing structure is the model in which employees get some percentage of the firm's revenue and can enjoy a part of the firm's success.

The revenue-sharing structure will help the firm to ensure that every employee in the firm is reimbursed fairly. The major advantage of this model is, employees are motivated to work in the favor of the firm and produce work of the best quality. However, in some situations, employees might not be able to produce the desired revenue for the company. Even in such a scenario, the firm is liable to pay a part of its revenue to its employees.

Principal-Agent Problem Solution Approach: Long-Term Contracts

Another possible solution to the principal-agent problem is by giving long-term contracts to the employees. By providing employees with long-term contracts, firms can give their employees a feeling of assurance and motivate them to serve in the best interest of the company.