Principle Agent Problem

world of economics

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Definition

The principle agent problem arises when one party (agent) agrees to work in favor of another party (principle) in return for some incentives. Such an agreement may incur huge costs for the agent, thereby leading to the problems of moral hazard and conflict of interest. Owing to the costs incurred, the agent might begin to pursue his own agenda and ignore the best interest of the principle, thereby causing the principal agent problem to occur.

Description

The costs to agent and subsequent conflict of interest arise due to the skewed information symmetry and the risk of failure faced by the principal.

Reasons Behind Principal-Agent Problems

The main reasons for the principal-agent problem are conflicts of interests between two parties and the asymmetric information between them (agents tend to possess more information than principals). The principal-agent problem generally results in agency costs that the principal should bear. Because agents can act in their interests at the principals’ expense, the principal-agent problem is an example of a moral hazard.

The principal-agent problem was conceptualized in 1976 by American economists, Michael Jensen and William Meckling. The problem has applications in political science and in economics. It is especially significant in the understanding of corporate governance.

Examples of Principal-Agent Problem

The following cases are among the most common examples of the principal-agent problem:

Shareholders (principal) vs. management (agent)

Voters (principal) vs. politicians (agent)

Financial institutions (principal) vs. rating agencies (agent)