Principal-Agent Problem

The Principal-agent problem is a specific game-theoretic description of a situation whereby there is a player called the principal and, one or more other players known as agents. The two parties in this situation have utility functions that are in a way different from one another. Principal-agent problem can be said to arise when one party (agent) agrees to work in the favor of another party (principal) in return for some incentives. Such an agreement may be very costly for the agent, thus, leading to the problems of conflicts of interest and moral hazards. Based on the costs incurred, the agent might start to pursue his own agenda, ignoring the best interest of the principal, hence causing the principal-agent problem.

The costs incurred by the agent and the subsequent conflict of interest come about due to the skewed information symmetry and the risk of failure faced by the principal. For instance, shareholders of a company conduct the appointment of managers to look after the proceedings of the company and earn profits on their behalf. The shareholders expect the managers to undertake the distribution of profit to shareholders. However, the managers realizing their own growth and salary expectation try to retain the profits for the future in order to be on the safe side. Such a practice can lead to principal-agent problem.

Today, the principal-agent problem is s common occurrence in most large corporations. The main area where the problem originates is that, the incentives to the agent are not necessarily going to lead to the behavior which best interests the principal. What is in the best interests of the management is not necessarily similar to what is in the best interests of the shareholders. In the case of large corporations, the shareholders are the principals while the management is the agents.

The problem comes up where the two parties (principal and agent) have different interests and asymmetric information (the agent is highly informed than the principal), such that the principal is not able to directly ensure that the agent is always acting in its (principal’s) best interest. Especially when activities that are of value to the principal are costly to the agent, and where elements of what the agent does are expensive to the principal. Concerns of the principal in such a case are based on the possibility of being exploited by the agent that he chooses not to get into any transaction at all, when the deal would have actually been in the interest of both parties.

There are various avenues that can be pursued in aligning the interests of the agent with those of the principal. In an employment scenario, employers (principal) may use mechanisms like profit sharing, piece rates/ commissions, efficiency wages, the threat of terminating the employment of affected employees, performance measurement among others. Cash bonuses for meeting certain targets are yet other avenues that can be pursued towards combating the principal-agent problem.

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