The Principal-Agent Problem - YouTube

Hey everyone. Noah Zerbe here. This is one of  a series of videos looking at key concepts in  

decision making. This video focuses in particular  on the principal agent problem. The principal  

agent problem can emerge anytime responsibility  for carrying out a specific task or course of  

action is delegated from one person to another.  The person delegating authority is the principal,  

and the person responsible for acting or making  decisions on behalf of the principal is the agent.  

But what happens if the interests and actions  of the principal and the agent are not aligned?  

This is the realm of the principal agent problem.  The concept itself emerges out of the business  

and economics literature to describe the tensions  between owners of a business and the managers of  

that business. In its simplest form, it describes  the tension between the principals--the owners  

of a company or the shareholders who wish to  maximize profits and increase stock dividends--and  

their agents--the managers of a company who may  be driven by a number of other motivations beyond,  

or at least in addition to, simple profitability.  The principal agent problem can be applied to  

a number of scenarios. Real estate agents  often have an interest in selling a house as  

quickly as possible, even if that means that they  might earn a little less money from the sale.  

This is because the costs they incur in selling  a house are greater than the extra profits they  

may earn from waiting a little longer. Thus the  interests of the real estate agent (the agent)  

and the homeowner (the principal) are not  aligned, and a principal agent problem can emerge.  

Or think about a student who pays someone else  to write their essay. The student (the principal)  

would like the highest quality paper. But the  anonymous author (the agent) is more interested  

in taking as little time as possible to complete  the essay, and may not even really care about  

getting caught by the professor. Again, their  interests are not aligned. And what about the  

competing interests between a landlord and a  tenant? The landlord would like to charge as  

much rent as possible while having a tenant who  takes good care of their property but doesn't  

demand too much from them in terms of property  maintenance and improvements. The tenant,  

by contrast, would like to pay as little as  possible and would like to see improvements and  

maintenance to the home performed by the landlord,  but doesn't necessarily care about the long-term  

quality of the home. Again, their interests are  not aligned. In the context of policy making,  

the principal agent problem emerges when the  interests and goals of the various layers  

of policy making are not clearly aligned.  Imagine a mid-level public official--say,  

a foreign service officer working in the State  Department. Such an individual is likely a career  

civil servant with years of experience  working in countries around the world.  

After a new president is elected, they generally  appoint new senior leadership to positions within  

the State Department and other governmental  departments and agencies. Such leadership  

encompasses the Secretary of State, the Under  Secretaries of State with specific portfolios,  

and dozens of Assistant Secretaries of State,  and so on. The President has their own goals,  

priorities, and interests, but must delegate  work and authority to the various Secretaries  

who operate relatively independently on behalf of  the President. That senior political leadership,  

in turn, is dependent on the bureaucracy--in  this case, the civil servants that comprise  

the State Department--to carry out their mandates.  At each level a potential misalignment between the  

interests and goals of the principal--the person  who wish whose wishes are to be carried out--and  

the agent--the person responsible for carrying out  the actions--can occur. Perhaps the Secretary of  

State has their own goals which are at odds with  those of the President. Or perhaps the Secretary  

is unintentionally miscommunicating them to the  various Under Secretaries. And the same situation  

can occur at lower levels, where the Under  Secretaries may be the principal whose interests  

do not clearly align with the agents-- the career  civil servants. The principal agent problem  

highlights several challenges for policy making.  First, it points to the fact that the interests  

and goals of the principal and agents--or between  elected government officials and career civil  

servants--may be misaligned or even divergent.  Slippage may occur when the agent sometimes  

comes to operate in pursuit of their own interests  rather than those of the principal. Or agents may  

engage in shrinkage, minimizing their own efforts  to pursue the principal's interests. Second,  

it also points to the problems of information  asymmetry between the principal and the agent. In  

this case, professional civil servants likely have  access to greater knowledge and information about  

the problems and processes used to address them  than the political leadership does. As a result,  

priorities established by the principle may be  based on incomplete or imperfect information,  

creating problems for those who are charged with  implementing policies. Relatedly, it can create  

problems of adverse selection, where the agent may  be actively trying to conceal information from the  

principal. All of these represent challenges  emerging from the principal agent problem.  

While the principal agent problem can represent  a real obstacle in implementing policy decisions,  

there are several ways to try to reduce or  overcome it. First, in the private sector,  

changing financial incentives is often used as a  mechanism to try to align interests. Thus managers  

might receive stock options as a part of their  compensation. In doing so, their interests in a  

variety of areas might come to more directly align  with those of the stock owners--the principals.  

But as we saw with the example of the real estate  agents who sells the house more quickly at a lower  

price, such incentives may not be entirely  effective. In the public sector, finding  

ways to align the interests between principals  and their agents might still occur, even if  

the vehicle to achieve these is not primarily  financial. Increased monitoring and oversight,  

for example, can reduce the principal agent  problem, albeit at an increased cost, primarily  

in terms of reduced efficiency in decision making  and implementation. After all, the main reason to  

employ agents to carry out decisions and operate  on behalf of the principal is to free time and  

energy for the principal to focus on other issues.  If they have to use some of that time monitoring  

implementation, then the utility of an agent is  reduced. So that concludes our brief introduction  

to the principal agent problem. I hope you found  it useful. Please feel free to leave any questions  

you have in the comments section below, and thanks  for watching. Have a good day everyone. Bye.