What is Principal-agent problem?
The principal-agent problem arises when one party (the agent) is hired to act on behalf of another (the principal) but has different interests, information, or incentives. It is a central problem in economics, corporate governance, and organizational design.
How it works
The core challenge is information asymmetry: the principal cannot perfectly observe the agent’s effort or intentions. A shareholder (principal) cannot monitor every decision a CEO (agent) makes, creating room for the CEO to pursue personal interests like empire-building or excessive perks. Solutions include performance-based compensation, monitoring systems, reputation mechanisms, and aligning incentives through equity ownership.
Applied example
A real estate agent tasked with selling your house may push for a quick sale at a lower price because their commission barely changes whether the house sells for $300,000 or $310,000, but the extra weeks of showings cost them significant effort.
Why it matters
The principal-agent framework explains why incentive design is so important in employment contracts, healthcare, financial advisory, and government, anywhere one party delegates decisions to another.
