Principal-Agent Problem

Search Dictionary

Definition of 'Principal-Agent Problem'

The principal-agent problem is a situation in which one party (the principal) hires another party (the agent) to perform a task on their behalf. The principal-agent problem arises because the principal and the agent have different interests and incentives. The principal wants the agent to act in their best interests, but the agent may have their own interests that conflict with those of the principal.

This problem can be illustrated by the example of a company hiring a CEO. The company (the principal) wants the CEO (the agent) to make decisions that will maximize the company's profits. However, the CEO may have their own interests, such as increasing their own salary or power, that conflict with the company's interests.

The principal-agent problem can lead to a number of problems, such as:

* **Moral hazard:** This occurs when the agent takes on more risk than the principal is willing to bear. For example, a CEO may take on risky investments that could benefit them personally, but could harm the company.
* **Asymmetric information:** This occurs when the agent has more information than the principal. For example, a doctor may have more information about a patient's condition than the patient does. This can lead to the principal making decisions that are not in their best interests.
* **Opportunism:** This occurs when the agent takes advantage of the principal's trust. For example, a salesperson may lie to a customer about the quality of a product in order to make a sale.

There are a number of ways to address the principal-agent problem, such as:

* **Contracting:** The principal can write a contract that specifies the agent's duties and responsibilities, and the consequences for not meeting those responsibilities.
* **Monitoring:** The principal can monitor the agent's behavior to ensure that they are acting in the principal's best interests.
* **Incentives:** The principal can provide incentives for the agent to act in their best interests, such as bonuses or stock options.

The principal-agent problem is a common problem in business and economics. It is important to be aware of the potential problems that can arise from this problem, and to take steps to address them.

Do you have a trading or investing definition for our dictionary? Click the Create Definition link to add your own definition. You will earn 150 bonus reputation points for each definition that is accepted.

Is this definition wrong? Let us know by posting to the forum and we will correct it.