Principal-Agent Problem

Definition of 'Principal-Agent Problem'

Conflicts of interest and moral hazard issues that arise when a principal hires an agent to perform specific duties that are in the best interest of the principal but may be costly, or not in the best interests of the agent. The principal-agent problem develops when a principal creates an environment in which an agent has incentives to align its interests with those of the principal, typically through incentives. Principals create incentives for the agent to act as the principal wants because the principal faces information asymmetry and risk with regards to whether the agent has effectively completed a contract.

Investopedia explains 'Principal-Agent Problem'

The principal-agent problem can be associated as part of agency theory. It has similarities to game theory in that the "rules" are changed to favor specific actions favored by the principal.

An example of how the principal-agent problem occurs between ratings agencies and the company's (the principal) 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.