Principal-agent problem

What is the principal-agent problem?

A principal-agent problem can arise when a person or organization delegates an action to another party whose interests differ, especially when relevant information or actions are difficult to observe. The delegating party is the principal; the acting party is the agent.

Hidden actions and incentives

Holmström’s analysis (1979) examines a hidden-action problem in which incentives must be balanced against risk sharing. Paying for measured outcomes can change effort incentives while exposing an agent to risks outside their control.

Principal-agent problem example

A homeowner may gain substantially from a higher sale price, while a commissioned agent receives only a fraction of that increase and must spend more time finding the buyer. They may therefore value a quick sale differently. This illustrates a possible incentive conflict; it does not tell us what a particular agent will do.

Responses to the principal-agent problem

Monitoring and compensation arrangements are possible responses, with costs and trade-offs. The useful task is to specify the delegated action, available information, incentives, and observed outcomes.

Moral hazard is one problem associated with actions that are difficult to observe.