# Principal-Agent Problem Causes, Solutions, and Examples Explained

![Principal-Agent Problem: A conflict in priorities between the owner of an asset and the person to whom control of the asset has been delegated.](https://www.investopedia.com/thmb/P3-9UFjGYy6mv9qFEnVSfQ-6ibQ=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/principal-agent-problem.asp-final-0bb85e21fd074d9987e0c6ea238750ab.jpg)

*— Investopedia / Sabrina Jiang*

## What Is the Principal-Agent Problem?

The principal-agent problem is a conflict in priorities between a person or group of people and the representative authorized to act on their behalf. An [agent](https://www.investopedia.com/terms/a/agent.asp) may act in a way that is contrary to the best interests of the [principal](https://www.investopedia.com/terms/p/principal.asp).

The principal-agent problem is as varied as the possible roles of a principal and agent. It can occur in any situation in which the ownership of an asset, or a principal, [delegates direct control](https://www.investopedia.com/terms/d/del-credere-agency.asp) over that asset to another party, or agent.

### Key Takeaways

*   The principal-agent problem is a conflict in priorities between the owner of an asset and the person to whom control of the asset has been delegated.
*   The problem can occur in many situations, from the relationship between a client and a lawyer to the relationship between a company's stockholders and its CEO.
*   The risk that the agent will act in a way that is contrary to the principal’s best interest can be defined as agency costs.
*   Resolving a principal-agent problem may require changing the system of rewards to align priorities, improving the flow of information, or both.

## Understanding the Principal-Agent Problem

The principal-agent problem has become a standard subject in political science and economics. The theory was developed in the 1970s by Michael Jensen of Harvard Business School and William Meckling of the University of Rochester.

In a paper published in 1976, they outlined a theory of an ownership structure designed to avoid what they defined as agency cost and its cause, which they identified as the separation of ownership and control.

This separation of control occurs whenever a principal hires an agent. The principal delegates a degree of control and the right to make decisions to the agent, but the principal retains ownership of the assets and the liability for any losses.

For example, stock investors, as part-owners of a company, are principals who rely on the company's chief executive officer (CEO) as their agent to carry out a strategy in their best interests. They want their stock to increase in price, pay a [dividend](https://www.investopedia.com/terms/d/dividend.asp), or both. If the CEO opts instead to plow all the profits into expansion or pay big [bonuses](https://www.investopedia.com/terms/b/bonus.asp) to managers, the principals may feel they have been let down by their agent.

![Principal-Agent Problem](https://www.investopedia.com/thmb/gJFGJsdZaTF-Qf_sC2EiOq4kLBI=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/principal-agent-problem.asp-d638930e39bf4aa1b0bc8ef42c31d406.jpg)

*Getty Images, Sabrina Jiang.*

There are a number of remedies for the principal-agent problem, and many of them involve clarifying expectations and monitoring results. The principal is generally the only party who can or will correct the problem.

## What Causes the Principal-Agent Problem?

### Agency Costs

The principal cannot constantly monitor the agent’s actions. The risk that the agent will shirk a responsibility, make a poor decision, or act in a way that is contrary to the principal’s best interest can be defined as [agency costs](https://www.investopedia.com/terms/a/agencycosts.asp).

Additional agency costs can be incurred while dealing with problems that arise from an agent's actions. Agency costs are viewed as a part of [transaction costs](https://www.investopedia.com/terms/t/transactioncosts.asp).

Agency costs may also include the expenses of creating incentives to encourage the agent to act in a particular way. Principals are willing to bear these additional costs as long as the benefits outweigh the costs.

## Solutions to the Principal-Agent Problem

The onus is on the principal to create incentives for the agent to act as the principal wants. Consider the first example, which concerns the relationship between [shareholders](https://www.investopedia.com/terms/s/shareholder.asp) and a CEO.  

### Contract Design

The shareholders can take action before and after hiring a manager to overcome some risks.

First, they can write the manager's contract in a way that aligns the incentives of the manager with the incentives of the shareholders. The principals can require the agent to regularly report results to them. They can hire outside monitors or auditors to track information.

In the worst case, they can replace the manager.

Designing a contract involves linking the interests of the principal and agent by tackling issues such as misaligned information, setting methods to monitor the agents, and incentivizing the agent to act in the best way possible for the principal.  

### Performance Evaluation and Compensation

Compensation is a motivating factor and a high priority for an agent. Linking compensation to certain criteria, such as a performance evaluation, can ensure that the agent performs at a high level. It is the most straightforward way to align the interests of the principal and the agent.

Methods of agent compensation include stock options, [deferred-compensation plans](https://www.investopedia.com/terms/d/deferred-compensation.asp), and [profit-sharing](https://www.investopedia.com/terms/p/profitsharingplan.asp).

At its root, it's the same principle as [tipping for good service](https://www.investopedia.com/tipflation-8180832). Theoretically, tipping aligns the interests of the customer (the principal), and the agent (the waiter). Their priorities are now aligned and are focused on good service.

## Examples of the Principal-Agent Problem

The principal-agent problem can crop up in many day-to-day situations beyond the financial world.

*   A client who hires a lawyer may worry that the lawyer will wrack up more billable hours than are necessary.
*   A homeowner may disapprove of the City Council's use of [taxpayer funds](https://www.investopedia.com/articles/personal-finance/021214/why-do-so-many-people-fall-behind-their-taxes.asp).
*   A home buyer may suspect that a realtor is more interested in a commission than in the buyer's concerns.

In all of these cases, the principal has little choice in the matter. An agent is necessary to get the job done. The principal can, however, hire a different lawyer, elect a new council member, or contact another realtor.

## Why Do Principal-Agent Problems Occur?

A principal-agent problem can be caused by poor communication, conflicting priorities, or plain incompetence.

Imagine a conservative investor who finds out that all of the family funds entrusted to a financial advisor have been invested in an obscure cryptocurrency. Or, a wife embroiled in a difficult divorce who finds out her lawyer has promised her beloved dog to her ex.

The solution is clear communication, preferably at the start of the principal-agent relationship, concrete incentives offered for good performance, or both.

This is called aligning the interests of the principal and the agent.

## What Causes the Principal-Agent Problem?

The primary cause of the principal-agent problem is known as agency costs. These costs arise due to the inability of the principal to constantly monitor the work of the agent, which could result in the agent avoiding responsibilities, making poor decisions, or acting in a way contrary to the interests of the principal.  

## What Is a Principal-Agent Problem in Politics?

  

As with any principal-agent problem, the issue arises when a constituent, or principal, disagrees with the actions of an elected politician, or agent. In this case, the agent has many principals to answer to. The fundamental power held by every one of those principals is their vote.

## The Bottom Line

The principal-agent problem is a conflict between the goals of an individual or group and the actions of an individual charged with representing them. Agents may avoid responsibility, make poor decisions, or otherwise engage in actions that are not beneficial to those they represent.

The agent-principal problem can often be avoided by communicating expected results clearly at the start of the agreement. If that doesn't work, a principal can provide incentives that motivate the agent to work in the best interest of the principal.

> **Article Sources**
>
> 1.  Jensen, Michael C. and Meckling, William H.. "[Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure](http://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf)." _Journal of Financial Economics_, vol. 3, no 4, Fall 1976, pp. 305-360.