The Principal-Agent Problem

What happens when one person acts on behalf of another whose interests differ, and how contracts, incentives and monitoring try to align them.

A great deal of economic life involves one person acting on behalf of another. Shareholders hire managers to run companies. Patients rely on doctors to recommend treatments. Homeowners hire builders. Voters elect politicians. In each case, economists call the person who delegates the principal and the person who acts the agent.

The problem

The principal-agent problem arises when two conditions hold. First, the agent’s interests differ from the principal’s. Second, the principal cannot fully observe what the agent does, a situation called hidden action.

A company’s shareholders want the firm run to maximise its long-term value. Managers might prefer a comfortable life, a larger empire, or short-term results that boost their bonus. Shareholders cannot see every decision the managers make, so they cannot simply insist on the best one.

Solutions

Principals use several tools to align interests:

Incentive pay: tie the agent’s pay to results, such as sales commissions, profit bonuses or stock options for managers.
Monitoring: watch what the agent does, through audits, inspections or supervisors.
Reputation: agents who want repeat business have reasons to behave well.
Rules and professional duties: laws and codes of conduct require doctors, lawyers and financial advisers to act in their clients’ interests.

Each has costs. Monitoring is expensive. Incentive pay can backfire when results are hard to measure.

Paying for the wrong thing

A call centre pays workers per call handled, hoping to raise productivity. Workers respond by rushing callers off the phone, and customer problems go unresolved, leading to more repeat calls. The incentive encouraged what was measured, not what the company actually wanted. Economists call this a problem of multitasking: when only some parts of a job are measured, rewarding them can crowd out the others.

Everyday examples

Estate agents paid a commission may prefer to sell a home quickly rather than hold out for a higher price, since a small price increase adds little to their commission but extra weeks of work cost them time. Research by Steven Levitt and Chad Syverson found that estate agents in Chicago kept their own homes on the market longer and sold them for more than similar homes they sold for clients.

Assuming incentive pay always solves the problem

Linking pay to results can help, but only when results are measured well and are mainly under the agent's control. Poorly designed incentives can encourage gaming, short-term thinking or even fraud.

Key takeaways

The principal-agent problem arises when an agent's interests differ and their actions are hidden.
Shareholders and managers, patients and doctors, voters and politicians all face it.
Incentive pay, monitoring, reputation and rules help align interests, each with costs.
Badly designed incentives can reward the wrong behaviour.