Principal-Agent Problem

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DEFINITION of 'Principal-Agent Problem'

The principal-agent problem develops when a principal creates an environment in which an agent's incentives don't align with its own. Generally, the onus is on the principal to create incentives for the agent to ensure they act as the principal wants. This includes everything from financial incentives to avoidance of information asymmetry.

BREAKING DOWN 'Principal-Agent Problem'

The principal-agent problem was first written about in the 1970s by theorists from the fields of economics and institutional theory. Michael Jensen of Harvard's Business School and William Meckling of the University of Rochester published a paper in 1976 outlining a theory of ownership structure that would be designed in such a way as to avoid what they defined as agency cost and it's relationship to the issue of separation and control.

These issues are central to the principal-agent problem. The separation of control occurs when a principal hires an agent, and the costs that the principal incurs while dealing with an agent can be defines as agency costs. These agency costs can come from setting up monetary or moral incentives set up to encourage the agent to act in a particular way.

Principal-Agent Problem Examples

The principal-agent problem is broad enough one that it can be found in a wide variety of contexts.

An example of how the principal-agent problem occurs between ratings agencies and the companies (the principals) that hire them to set a credit rating. Because a low rating will increase the cost of borrowing for the company, it has an incentive to structure its compensation of the rating agency so that the agency gives a higher rating than what may be deserved. The rating agency is less likely to be objective because it fears losing future business by being too strict.

A principal-agent problem could just as easily occur if one person, the principle, asks another, the agent, to buy them some ice-cream without the agent knowing the flavor preferences of the principle. While the two may have discussed the pay-rate for purchase and deliver of the ice cream, the number of scoops, whether in a cup, cone, or waffle cone, and the delivery date and time, preference in taste was left out and the agent can't pick.

A more common example would be when a person (principle) takes in their car to be serviced by a mechanic (agent). That agent knows more than the typical principle, and the agent has the ability to charge at their own discretion.

Contract Design

Because so much of the principal-agent problem has to do with information asymmetry and incentives, one of the best ways to protect against an agent acting out of self-interest as opposed to the interest of the principal is to be very intentional about the language of a contract and the types of incentives being laid out. 

Employee Compensation

A popular view on employment contracts is to connect compensation as closely as possible with performance measurements. Depending on the business, industry, and individuals, this can all vary. According to Peter Doeringer and Michael Piore's 1971 paper "Internal Labor Markets and Manpower Analysis," the labor market can be divided into "primary" and "secondary" markets, depending on how different workers will be compensated. Those in the primary market tend to be compensated according to skill, while those in the secondary market have their wages determined primarily by market forces. 

Tipping as a form of payment can be seen as a way to combat the principle-agent problem. Theoretically tipping aligns the interest of the principle (quality of service) with that of the agent, because presumably that is the metric that the customer uses to determine the tip. However, in the particular case of tipping in restaurants the practice is inexact. The amount one is tipped has been shown not to correlate with quality of service, and can in fact be discriminatory.

Other forms of compensation can help align an employees interests with that of their employers. For example, performance pay schedules may decrease the quality of an employees work if the employee feels their effort is not being effectively recognized. 

Deferred compensation, essentially paying an agent when the task is complete, is another way of designing around the principal-agent problem. Within this system, however, there are still variables: older workers may get paid more and younger ones get paid less due to age discrimination; or quality of performance evaluation might be skewed to the end of the performance period. 

Principles of Contract Design 

Four principals of contract design as laid out by Milgrom and Roberts in 1992 can help draft better contracts.

  • Holmstrom's informativeness principle, introduced in 1979, states that any available measure of performance by the agent should be factored into the level of compensation in the contract.
  • The incentive intensity principle argues that the best kind of incentives are created by four factors: profit created, precision, agent's risk, and agent's responsiveness to incentives. This principle posits that the more compensation varies with effort, the better the agent responds to incentives.
  • the monitoring intensity principle states that the level of monitoring will correlated with the level of incentives being offered to the agent. 
  • The equal compensation principle states that compensation for an activity should also match the value a principle puts on the completion of that activity. This helps agents better prioritize the importance of tasks when engaged in multiple projects.

Energy Efficiency 

Principal-agent problem can also be applied to energy consumption. When trying to catalog barriers to energy efficiency within and without the market, Jaffe and Stavins found a problem that could be defined as a principal-agent one when looking at energy saving appliances. If, for example, the electrical utilities are covered by the landlord, the tenant is less likely to purchase appliances that are energy efficient. This particular example is unique in that it is hard to determine who is the principal and who is the agent in the landlord and tenant relationship. In addition, information asymmetry doesn't play as much of a role in this relationship. Both parties can be aware of the benefits of cost-saving appliances but not use them.

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