The conflict of interest between the agent and the principal Show
What is a Principal-Agent Problem?A principal-agent problem arises when there is a conflict of interest between the agent and the principal, which typically occurs when the agent acts solely in his/her own interests. In a principal-agent relationship, the principal is the party that legally appoints the agent to make decisions and take actions on its behalf. To learn more about similar topics, you can take CFI’s behavioral finance fundamentals course, which explores the fundamental issues of psychology on the behavior of financial agents.  The separation of the “ownership” (principal) and the “control” (agent) in principal-agent relationships creates the grounds for potential conflict of interests between the two parties. Reasons Behind Principal-Agent ProblemsThe main reasons for the principal-agent problem are conflicts of interests between two parties and the asymmetric information between them (agents tend to possess more information than principals). The principal-agent problem generally results in agency costs that the principal should bear. Because agents can act in their interests at the principals’ expense, the principal-agent problem is an example of a moral hazard. The principal-agent problem was conceptualized in 1976 by American economists, Michael Jensen and William Meckling. The problem has applications in political science and in economics. It is especially significant in the understanding of corporate governance. Examples of Principal-Agent ProblemThe following cases are among the most common examples of the principal-agent problem:
Solutions to the ProblemSolutions to the principal-agent problem aim to align the interest of both parties. There are two main areas of improvement to address the problem: 1. Contract designThe main purpose of contract design is the creation of a contract framework between the principal and the agent to address issues of information asymmetry, stimulate the agent’s incentives to act in the best interests of the principal, and to determine procedures for monitoring agents. 2. Performance evaluation and compensationThe agent’s compensation is the primary method of aligning the interests of both parties. In order to address the principal-agent problem, the compensation must be linked to the performance of the agent. The performance of the agent is usually measured by subjective evaluation because it is a more flexible and balanced assessment method for complex jobs. Common methods of agent compensation include stock options, profit-sharing, and deferred compensation. Tying the agent’s compensation closely to the benefits obtained for the principal helps to eliminate conflicts of interest. Related ReadingsThank you for reading CFI’s guide on Principal-Agent Problem. To keep learning and advancing your career, the additional CFI resources below will be useful:
What is a principalPrincipal–agent problems occur when I (the "agent") make decisions on behalf of, or that impact, you (the "principal").
Is tipping an example of the principal–agent problem?The issue of tipping is sometimes discussed in connection with the principal–agent theory. "Examples of principals and agents include bosses and employees ... [and] diners and waiters." "The "principal–agent problem", as it is known in economics, crops up any time agents aren't inclined to do what principals want them to do.
What are some examples of principals and agents?"Examples of principals and agents include bosses and employees... [and] diners and waiters." "The "principal–agent problem", as it is known in economics, crops up any time agents aren't inclined to do what principals want them to do.
What is an example of moral hazard in principal agent problem?Principal-Agent Problem and Moral Hazard. The principal-agent problem can also lead to an individual taking an excessive risk because the ultimate cost is borne by someone else. This is an example of moral hazard. For example, an investment banker may gain a bonus for making high profits.
What is an example of a principalCommon examples of the principal-agent relationship include hiring a contractor to complete a repair on a home, retaining an attorney to perform legal work, or asking an investment advisor to diversify a portfolio of stocks.
What is principalThe principal-agent problem is a conflict in priorities between a person or group and the representative authorized to act on their behalf. An agent may act in a way that is contrary to the best interests of the principal.
What are some examples of agency problems?For example, a principal will hire a plumber—the agent—to fix plumbing issues. Although the plumber's best interest is to collect as much income as possible, they are given the responsibility to perform in whatever situation results in the most benefit to the principal.
How do you solve principalThe best way to solve the principal-agent problem is to craft the right incentives for the agents. And these incentives should align with the incentives of the principal. Incentives are rewards and punishments that impact human behavior.
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Principal agent problem examples
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