Principal-Agent Problem

Are you tired of feeling like you're being taken advantage of? That's exactly how principals feel in the principal-agent problem. This issue arises when a principal, such as a client, hires an agent, such as a financial advisor, to act on their behalf, but the agent's interests don't align with those of the principal. In this article, we'll explore the definition and causes of the principal-agent problem and provide real-world examples of this concept. But don't worry, we won't leave you hanging. We'll also discuss the principal-agent problem solution approach and how to combat moral hazard in the principal-agent relationship. So, sit back, relax, and get ready to be an informed principal!

Principal-Agent Problem Principal-Agent Problem

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Table of contents

    Principal-Agent Problem Definition

    Let's have a look at the principal-agent problem definition.

    The principal-agent problem is the situation that develops when agents start pursuing their objectives rather than that of the principal.

    The principal is the party that employs an agent to act on behalf of their objectives.

    An agent is a party who is assigned by the principal to achieve their objectives.

    The principal-agent problem arises when the agents try to pursue their objective at the expense of the principal's objective. In this situation, the principal's welfare depends on the actions taken by agents.

    Principal-Agent Problem Example

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

    Imagine that you were driving down the road when your car broke down, and you went to the mechanic to get it fixed. While you are unaware of the exact problem your car is experiencing, the mechanic can recognize it easily. You are the principal in this scenario, and the mechanic is the agent.

    Your objective is to repair the car, but what if the mechanic has the objective of maximizing his profits? He used the fact that you and he had different levels of knowledge regarding the issue with the car to his advantage, charging you more for repairs to pursue his goals. Hence, in this way, the principal-agent problem arises.

    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.

    Revenue from Sales of Jewelry
    Bad LuckGood Luck
    Low Effort$50,000$80,000
    High Effort$80,000$100,000

    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.

    Asymmetric information is the information gap between buyers and sellers in an economic transaction, which can lead to market failure in the long run.

    We have covered Asymmetric Information in detail. Please don't hesitate to check it out!

    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.

    Let us assume, Alexis gets his car fully insured against physical damage and theft. As he has insured his car, now his behavior might change, and he might start driving rashly or might not lock the car. Alexis knows that he cannot be observed by the insurance company, which incentivized him to alter his behavior. In this situation, Alexis is the agent and the insurance company is the principal. Hence, the change in Alexis's behavior as he is insured is a problem of moral hazard.

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

    A moral hazard is a situation when one party changes their behavior in an undesirable way, knowing that it cannot be observed by the other party.

    We have covered the Moral Hazard in detail. Do check it out!

    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.

    Other solutions to the principal-agent problem include better monitoring and delayed payment.

    Principal-Agent Problem - Key Takeaways

    • The principal-agent problem is a situation that develops when agents start pursuing their objectives rather than that of the principal.
    • Asymmetric information is the information gap between buyers and sellers in an economic transaction, which can lead to market failure in the long run. Asymmetric information between the principal and the agent can cause an agent to change their behavior.
    • A moral hazard is a situation when one party changes their behavior in an undesirable way knowing that it cannot be monitored by another party.
    • Revenue-sharing structure and long-term contracts are two solutions to the principal-agent problem.
    Frequently Asked Questions about Principal-Agent Problem

    What is a principal-agent problem?

    The principal-agent problem is the situation that develops when agents start pursuing their own objectives rather than that of the principal.

    What causes the principal-agent problem?

    A major cause of the principal-agent problem is asymmetric information between the parties involved in an economic transaction. When one party takes advantage of asymmetric information at the expense of another party’s objective, a principal-agent problem arises. 

    What is a principal-agent example?

    Imagine that you were driving down the road when your car broke down, and you went to the mechanic to get it fixed. While you are unaware of the exact problem your car is experiencing, the mechanic can recognize them easily. You are the principal in this scenario, and the mechanic is the agent.

    How does the principal-agent problem affect growth?

    The principal-agent problem might have an impact on growth because the agent's pursuit of their own objective may result in market inefficiency.

    How might a business overcome the principal-agent problem?

    A business might overcome the principal-agent problem by using revenue-sharing structures with employees or giving them long-term contracts.

    Test your knowledge with multiple choice flashcards

    If an employee tries to pursue their personal goal over the firm's goal, the __________ problem arises.

    Asymmetric information can cause an agent to change their behavior.

    In a principal-agent problem, which party has more information than the other?

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