PrincipalAgent

Principal-agent problems arise when a principal delegates work to an agent whose actions are costly to observe and whose interests may diverge. The core issue is information asymmetry and misaligned incentives, which can produce suboptimal outcomes and higher costs for the principal. These agency costs include monitoring costs, bonding costs by the agent to assure the principal, and residual losses from remaining misalignment. In contract theory, the aim is to design arrangements that align incentives while sharing risk. The literature distinguishes hidden actions (moral hazard) and hidden information (adverse selection). A typical model ties an agent’s compensation to observable outcomes; the agent chooses effort to influence those outcomes, while randomness and risk aversion shape the contract.

Mitigation strategies include monitoring, performance-based pay, bonding provisions, and granting control rights or equity to align interests. In corporate governance, shareholders (principals) hire managers (agents); tools such as executive compensation, independent boards, audits, and clawback provisions seek to reduce agency costs. Similar issues appear in outsourcing, franchising, and public programs. Limitations exist: models rely on assumptions about rationality, risk preferences, and information structure; real-world relations often involve relational contracts, multiple principals, and reputational dynamics. Nonetheless, principal-agent theory offers a formal framework for analyzing contract design, governance, and incentives to improve alignment between principals and agents.