Imagine you have hired a real estate agent to sell your house. You want to get every last penny you can, but even if the agent manages to push the price up a little, the commission they pocket barely grows. So for the agent, closing the deal quickly at a reasonable price may pay off better than waiting several more weeks to sell at a higher one.
A conflict like this, which arises when the interests of the person who hands over a job and the person who takes it on pull apart, is called the ‘principal-agent problem’. It appears wherever someone entrusts work to someone else, as between shareholders and managers, companies and employees, or citizens and politicians, and it is also known simply as the agency problem.
In this article, we will look in turn at what the principal-agent problem means and why it arises, how it shows up in companies, the costs it imposes, and the ways to tie the interests of both sides in the same direction.
When the One Who Delegates and the One Who Acts Diverge: How the Principal-Agent Problem Works and How to Solve It
The Gap That Opens the Moment You Delegate
A principal-agent relationship arises when one person asks another to do a job on their behalf.
- Principal: the side that hands over the job and gains or loses from the result.
- Agent: the side that actually makes decisions and acts on the principal's behalf.
- Agency problem: the conflict that arises when the agent puts their own interests ahead of the principal's.
There are two main reasons the problem arises. First, the two people want different things. Second, the principal cannot fully see what the agent is doing or how hard they are working. This is called information asymmetry. If both wanted the same thing, or if every action were plainly visible, the agency problem would hardly arise at all.
The idea became established as an economic theory in the 1970s. The American economist Stephen Ross is said to have explained the difficulty by comparing it to choosing an ice cream flavour for someone whose tastes you do not know. When you act for someone else, however conscientious you are, a gap inevitably opens between what that person really wants and your own judgement.
Worries of a Company Without an Owner at the Helm
The place where this problem shows up most clearly is the joint-stock company. The owners of the company are the shareholders, but the people who actually run it are the managers.
(1) An Old Worry
Adam Smith, the father of economics, pointed out in The Wealth of Nations in 1776 that because the directors of joint-stock companies manage other people's money rather than their own, they cannot be expected to watch over it as carefully as they would their own.
(2) The Separation of Ownership and Control
In 1932, the American legal scholar Adolf Berle and the economist Gardiner Means argued that as the shares of large corporations became scattered among countless people, those who owned companies and those who ran them had split apart.
(3) Managers' Different Calculations
Managers may care more about their own position, reputation or the sheer size of the company than about its profits. Lavish offices and reckless mergers and acquisitions are often cited as examples. Because a manager's influence and pay tend to grow along with the company, they may choose to expand even through businesses that return little profit to shareholders.
The Price of Divergence
In 1976, the American economists Michael Jensen and William Meckling published a paper that set out this problem as a theory. It is regarded as the most widely cited study in agency theory today. They called the losses caused by the agency problem agency costs and divided them into three types.
(1) Monitoring Costs
The money the principal spends keeping an eye on the agent. External audits and running a board of directors fall into this category.
(2) Bonding Costs
The money the agent spends to show that they can be trusted. Publishing detailed performance reports is one example.
(3) Residual Loss
The loss that remains even after all the monitoring and bonding. It is the difference that arises because the agent's decisions differ from those the principal would have made themselves.
In fact, one American study found that real estate agents sell their own homes for about 3.7% more than their clients' homes. This means that when the job is their own, they wait longer and look for a better price.
Ways to Make Both Sides Look the Same Way
It is hard to eliminate the agency problem completely, but there are several ways to get the agent looking in the same direction as the principal.
(1) Linking Performance and Reward
When the agent's share grows as results improve, through sales commissions, performance bonuses or stock options, the interests of the two people move closer together.
(2) Putting Oversight in Place
Outside directors, external audits and transparent disclosure let the principal see what the agent is doing, narrowing the information gap.
(3) The Trap of Excessive Rewards
Tie rewards to a single number, and the agent will chase only that number. This is why fixation on short-term results can end up harming a company's future. That is also why rewards are often based on several indicators at once and paid out over a number of years.
Oliver Hart and Bengt Holmström, who studied which contracts work best in situations where information is unevenly shared like this, received the Nobel Prize in Economic Sciences in 2016.
The principal-agent problem reveals the gap that naturally opens the moment we trust someone with a job. It happens not because the agent is a bad person, but because what each side wants and what each side can see are different.
When delegating work, rather than relying only on the other person's goodwill, paving the way for both sides' interests to point in the same direction is the first step in management that builds healthy organizations and trust.
