Principal-Agent Problem

Principals hire agents to act for them because they lack the time, expertise or ability to do things themselves. But agents may be tempted to serve their own interests rather than those of the principal, and it can be difficult for the principal to monitor what the agent is doing.

A classic example is the relationship between shareholders and company managers. Shareholders, the principals, want managers to maximise the long-term value of the company. Managers, the agents, might instead pursue higher salaries, empire-building acquisitions, short-term results that boost bonuses, or a quieter life.

Other examples include clients and financial advisers, homeowners and estate agents, and voters and politicians.

Solutions include aligning incentives, for example by paying managers partly in shares; monitoring through boards of directors, audits and disclosure requirements; legal duties such as fiduciary obligations; and contracts that link pay to performance. The costs that arise from managing this problem are called agency costs.