The principal-agent model definition stems from Black's Law Dictionary of 1999, which defines a principal as someone authorizing another person to act on their behalf as an agent. The principal-agent model appears in many contexts, including when an employee acts on an employer's behalf by receiving certain benefits as a result of the employee's actions.

Principal-Agent Models

A principal-agent model refers to the relationship between an asset owner or principal and the agent or person contracted to manage that asset on the owner's behalf. For example, if you own a small business and hire an outside contractor to complete a service, you enter into a principal-agent relationship.

The main element in the principal-agent model is trust. You trust that both you and the agent acting on your behalf have the same incentives. Conflicts in those incentives arise and create what's known as a principal-agent problem.

Problems can occur when:

  • Agents have hidden agendas and substitute their own objectives for what the principal wants
  • Asymmetrical information favors agents and makes it difficult for principals to monitor an agent's activities
  • Agents shirk responsibilities and work at less-than-optimal efficiency

The Principal-Agent Problem

Issues surrounding the principal-agent problem involve the separation of control that occurs when the principal hires an agent to act on their behalf, not to mention the costs incurred by the principal in dealing with the agent (i.e., agency costs). The principal-agent problem was first addressed in the 1970s by economic and institutional theorists. A paper in 1976 by Michael Jensen and William Meckling outlined a theory of ownership structure that would best avoid agency costs and the relationship issues present in the principal-agent model.

Agency costs come from setting up moral or monetary incentives to encourage an agent to act in a certain way. Unless the incentives align, a principal-agent problem occurs. In other words, the principal-agent problem arises when an agent agrees to work for the principal in return for an incentive, but the agreement may incur excessive costs for the agent and lead to conflicts of interest or moral hazards. This situation may encourage the agent to pursue their own agenda and ignore what's best for the principal.

For example, consider a roofer who charges by the hour. The roofer might realize that taking as much time as possible to complete the task will reap him higher monetary rewards, so he performs the jobs slowly to bill more hours. Since the client doesn't know anything about roofing, they are powerless to prevent being taken advantage of. Although the client's roof gets fixed, they pay more than necessary because the roofer took his time.

Eliminating the Principal-Agent Problem

One of the best ways to deal with the principal-agent problem is to pay for services by the project instead of the hour. If the roofing contractor knows he'll make a certain amount of money for fixing the roof regardless of how long it takes, he'll perform the job more quickly. The key to eliminating the principal-agent problem is all about finding any conflict of incentives and getting rid of them.

You can eliminate the principal-agent problem by drawing up a solid labor contract. If the contract between the principal and agent provides a fixed wage regardless of the worker's effort, the worker won't have an incentive to work hard. The better solution is to make the wage dependent on the agent's effort, which can be difficult if the principal isn't there to monitor the agent's activities.

Examples of Principal-Agent Problems

One common example of the principal-agent problem occurs between hiring companies and agencies that set credit ratings. Since low ratings increase the borrowing costs for a company, the company is incentivized is to structure compensation in such a way that the rating agency provides a higher rating than the company might deserve. As such, the rating is not objective.

If you take your car to be serviced, you're at a disadvantage because the agent, or mechanic, knows more about servicing cars than you do, so they may charge more.

A simpler example is if a principal asks an agent to purchase some ice cream without telling the agent which flavor they prefer. Despite the fact that both parties discussed the payment, number of scoops, and delivery of the ice cream, the agent can't pick the principal's preferred flavor because it was left out of the agreement.

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