Principal–agent problem

The principal–agent problem (often abbreviated agency problem) refers to the conflict in interests and priorities that arises when one person or entity (the "agent") takes actions on behalf of another person or entity (the "principal"). The problem worsens when there is a greater discrepancy of interests and information between the principal and agent, as well as when the principal lacks the means to punish the agent. The deviation of the agent's actions from the principal's interest is called "agency cost". Common examples of this relationship include corporate management (agent) and shareholders (principal), elected officials (agent) and citizens (principal), or brokers (agent) and markets (buyers and sellers, principals). In all these cases, the principal has to be concerned with whether the agent is acting in the best interest of the principal. Principal-agent models typically either examine moral hazard (hidden actions) or adverse selection (hidden information). The principal–agent problem typically arises where the two parties have different interests and asymmetric information (the agent having more information), such that the principal cannot directly ensure that the agent is always acting in the principal's best interest, particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe. The agency problem can be intensified when an agent acts on behalf of multiple principals (see multiple principal problem). When multiple principals have to agree on the agent's objectives, they face a collective action problem in governance, as individual principals may lobby the agent or otherwise act in their individual interests rather than in the collective interest of all principals. The multiple principal problem is particularly serious in the public sector. Various mechanisms may be used to align the interests of the agent with those of the principal. In...