Principal–Agent Theory

The principal-agent problem happens quite often in business relationships. When a principal hires an agent to perform some tasks, the agent’s interest seems to lie in satisfying their employer. But so often there is a conflict of interest between the two parties or the agent finds the incentives are insufficient to cover the risk. The conflict often arises from the information asymmetry, when one party knows the information that is essential but unknown to the other party. The principal-agent problem also happens when the agent has an ethical conflict with their employer. They lack neither information nor incentives but still cannot perform as agreed. Here are some examples and ways of solving the principal-agent problem.

Information asymmetry happens when the agent is more informed than the principle. The company doing an interior design, for example, may choose costly materials to implement the principal’s draft. They are better aware of the materials and their quality, but the principal’s interest lies in low cost, and so the conflict happens. Detailed negotiations concerning every step of the plan and their expenses shall be conducted to avoid unpleasant surprises.

Ethical problems sometimes arise between the agent and the employer, and there are few ways to resolve them. Imagine the principal who hires a rating agency and demands to set a higher rating than it actually is. The agency, on the other hand, is not willing to risk their reputation. Aware of the conflict, the principal can offer a higher incentive to motivate the company to act against its best interests. Otherwise, the agency shall make it clear that the contract between them is impossible so that the principal starts to search for another agent.

Talking about a lack of incentives, imagine a landlord and their tenant. The landlord covers the electrical utilities, and tenants are not interested in purchasing energy efficient appliances. They are usually costly, and tenants are not motivated to spend more money to save the money of their landlord. In such case, the landlord has to put utility payments on the tenants to make energy efficiency their best interest.