Principal-Agent Problem

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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.

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RELATED FAQS
  1. What is the difference between a principle agent problem and moral hazard?

    Principal-agent problems and moral hazards are related in that one gives rise to the other. Principal-agent problems occur ... Read Full Answer >>
  2. How is the principle agent problem manifested in the government?

    The principal-agent problem describes challenges that occur when agents and principals have conflicting interests. Democratically ... Read Full Answer >>
  3. How does agency theory propose to deal with the agency problem?

    Agency theory highlights potential problems that may occur when agents and principals have different interests. Principals ... Read Full Answer >>
  4. What are some famous scandals that demonstrate the agency problem?

    The agency problem occurs when agents do not appropriately represent the best interests of principals. Principals hire agents ... Read Full Answer >>
  5. What are the different groups involved in corporate governance?

    To identify the particular groups involved in corporate governance, the scope of corporate governance needs to be established ... Read Full Answer >>
  6. Do employers use agency theory in labor relations?

    Agency theory is used in business relations to describe the potential problems that occur whenever the agent's interests ... Read Full Answer >>
  7. Does agency theory apply to brokers and clients?

    Agency theory describes the challenges arising from the different interests of agents and principals. Principals employ agents ... Read Full Answer >>
  8. What is the role of agency theory in corporate governance?

    Agency theory is used to understand the relationships between agents and principals. The agent represents the principal in ... Read Full Answer >>
  9. How do economists define moral hazard?

    An economist identifies moral hazard as any situation where one party has an incentive to use more resources than he otherwise ... Read Full Answer >>
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