The principal-agent problem is a key concept in economic theory, which has some fascinating consequences in real life. It is easier to understand the idea using the following example.
You want to buy a house. There are a lot of potential sellers in the market; you meet one of them, agree on a price and settle the deal – a simple transaction between a buyer and a seller. But real life is more complex. You may not know where those sellers are, the market value or the paperwork that may be required to complete the process etc. So you approach a real estate agent, who has more knowledge in this topic than you, the principal. In technical language, an asymmetry of information exists.
The agent knows something that you don’t. And she realises the value (say, buy the best house at the cheapest rate) on the principal’s behalf.
A far more complex principal-agent dynamics work in a large company. A simple owner-household transaction becomes a series of relationships between the owner (shareholders) – board, board-CEO, CEO-top management, manager – technical expert etc. Here, the lower-down person (in the hierarchy) needs to act to realise the values and visions of the higher.
So what’s the problem?
The biggest one is trust. Ideally, you want the incentives of both parties (the principal and the agent) to be aligned. But since the agent has more knowledge, you suspect the former to misuse the information asymmetry to her advantage. It leads to a conflict of incentives, and the principal can’t make it if the agent did a good deal or a bad deal on your behalf.
