The Principal-Agent Problem, or the Agency Problem, is an economic concept that examines the conflict between two parties when one party, the agent, is authorized to make decisions on behalf of the principal. This arises when the principal delegates certain tasks, such as financial investments, to the agent, and there is risk that the agent will prioritize their own interests over those of the principal. This is particularly common where the agent is in a far better position to acquire information about the task, and the principal only has an incomplete understanding of what is going on.

The agency problem has manifold expressions, and can be found in a wide range of business relationships. For example, in the context of a corporation, the problem appears when a CEO is given incentives or stock options not necessarily based on the performance of the company. As shareholders may go relatively unrewarded while the CEO continues to receive bonus payments or stock options, or takes part in insider trading, the problem of the Principal-Agent arises.

Another example can be found in the relationship between corporate boards of directors and the company’s executives — the agent. If the agent is not properly constrained by the terms of the agency contract, then it may be possible for the agent to divert corporate funds to investments that could be more profitable for the agent than for the company, without necessarily being in the shareholder’s best interest.

To address this problem, firms can use a variety of approaches. One is to increase the principal’s monitoring of the agent’s activities, which can be cost-prohibitive, however. Another is to design incentive mechanisms that more closely align the agent’s interests with the principal’s. These incentive mechanisms can include such things bonuses, stock options, or even the threat of termination of the agent’s contract.

In some instances, however, a contractual agreement between the principal and agent is not enough to protect the principal’s interests. Where agents are in a better position to acquire information than the principal, it may be necessary to increase the transparency and communication of information between the two parties. This can be achieved through the use of performance metrics and the sharing of data among the agent and principal, so that the principal has increased visibility into the agent’s activities and decision-making.

Ultimately, the goal is to ensure that the agent’s interests remain aligned with those of the principal. When agents are properly incentivized and monitored and decision-making processes are transparent, the issue of the Principal-Agent Problem can be significantly reduced.