Principal-Agent Problem

The principal-agent problem is the conflict that arises when one person or organisation, the principal, hires another, the agent, to act on its behalf, but the two have different goals and the principal cannot fully observe what the agent does or knows. Shareholders rely on managers to run a company, savers rely on fund managers to invest their money, patients rely on doctors, and voters rely on elected officials. In each case the agent may pursue its own interests at the principal's expense.

The problem combines asymmetric information with diverging incentives, and its core mechanism is moral hazard: once the relationship begins, the agent's effort and choices are hidden. The costs it creates are known as agency costs. Formal agency theory was developed in the 1970s by economists including Stephen Ross, Michael Jensen, William Meckling and Bengt Holmström, who shared the 2016 Nobel Prize in economics with Oliver Hart for their work on contract theory.

Suppose you hire a builder to renovate your kitchen and pay by the hour. You are at work all day, so you cannot see how quickly the job progresses. The builder has an incentive to take a little longer than necessary, while you want the job done well and fast. If you pay a fixed price instead, the builder may finish quickly but cut corners where you cannot see.

Neither arrangement is perfect, because you cannot watch everything. The principal-agent problem is the search for a deal that gives the person doing the work good reasons to act as you would if you were doing it yourself.

• Shareholders and managers. Adolf Berle and Gardiner Means warned in 1932 that dispersed ownership left managers of large US companies largely unchecked. Managers may build empires through mergers and acquisitions, enjoy perks, or favour short-term results that boost their pay.
• Investors and asset managers. A fund manager paid on assets under management may prefer to keep assets rather than return them, and a hedge fund manager with a share of profits but not losses may take extra risk.
• Clients and brokers. A broker paid by commission may trade more often than the client needs. In the US, the SEC's Regulation Best Interest has applied to broker-dealers since June 2020, and the UK banned commission payments for retail investment advice from the end of 2012.
• Depositors, creditors and banks. Bank managers acting for shareholders may take risks that fall on depositors and on deposit insurance funds.
• Citizens and governments. Officials may pursue their own careers or the interests of organised groups, a theme of public choice theory and the study of regulatory capture.

A central result of agency theory is that pay linked to outcomes can align interests, but at a cost. A simple linear contract pays the agent:

• $w$ is the agent's total pay.
• $a$ is a fixed salary paid regardless of results.
• $b$ is the share of measured output the agent keeps, between 0 and 1.
• $\pi$ is the measured output or profit.

Suppose a sales manager earns a salary of $60,000 plus 10% of the profit their division generates. If the division makes $500,000, pay is $60{,}000 + 0.10 \times 500{,}000 = 110{,}000$ dollars. A higher $b$ strengthens incentives, but it also exposes the manager to luck beyond their control, so a risk-averse agent demands more pay in return. Holmström's "informativeness principle" (1979) holds that pay should depend on any measure that reveals information about the agent's effort, which supports comparing executives with industry peers. His later work with Paul Milgrom showed that strong incentives on measurable tasks can cause agents to neglect tasks that are hard to measure.

• Ownership. Giving agents equity or stock options links their wealth to the principal's, a central idea behind the shareholder value movement.
• Monitoring. Boards of directors, an independent auditor, regulators and activist investors watch the agent's actions.
• Legal duties. Fiduciary duties of loyalty and care require agents such as trustees and company directors to put the principal's interests first.
• Reputation and competition. Agents who want future business, and managers who could be replaced through a takeover or a leveraged buyout, have reasons to behave well.

Critics argue that agency theory's focus on aligning managers with shareholders encouraged heavy use of stock-based pay that rewarded share-price manipulation and short-term thinking; supporters reply that the problem lay in poorly designed contracts rather than the theory. Advocates of stakeholder capitalism argue that companies serve several principals, including employees and communities, so maximising shareholder returns is too narrow a goal, while defenders of the shareholder model say that managers answerable to everyone are effectively answerable to no one. Research in behavioural economics adds that intrinsic motivation and trust matter, and that heavy monitoring can crowd out goodwill.

• The Nobel Prize: Economic Sciences 2016