Principal-Agent Problem

See: Principal. See: Agent.

You're a billionaire. Your parents made a fortune in aardvark farming during the 1980s, but were killed in a tragic stampede in 1993. You inherited the fortune, but don't have much interest in actually overseeing your investments, or keeping your aardvark empire intact. Instead, you split time between your Formula 1 racing team and a Lithuanian female wrestling league you bought a few years ago.

For your other investments, you've hired a manager: Earvin, a guy you met in prep school. You probably haven't noticed, but you've run directly into the principal-agent problem.

The term describes the underlying tension between the interests of the people who own an asset and the interests of the people who run it. For instance, Earvin has an incentive to pay himself a big salary. You'd rather pay him as little as possible. Earvin might be tempted to skim a little here and there, since you're distracted by racing and Lithuanian wrestlers. You, of course, hope he'll be honest and completely devoted to promoting your interests, even at the cost of his own. That tension defines the principal-agent problem.

It comes up in subtle ways in real life. The CEO of a company is supposed to do what's in the best interest of shareholders. That might involve flying coach if he needs to get to Washington DC for a meeting with regulators. But the corporate jet is just sitting there. Sure, the flight will cost $30,000 rather than the $225 it would cost to fly Southwest. But hey, it's not the CEO's money. Besides...all that waiting in the airport is a waste of valuable CEO time, right?

The principal-agent problem was among the key drivers in the rise of stock options and other equity compensation for executives. The tactic sought to align the interests of the owners and the managers more closely, by giving the managers an ownership stake in the company.

The principal-agent problem also exists outside the financial space. Take government. Elected officials are meant to manage the affairs of the citizens who voted them into office. They are the agents...we are the principals. But the same tension comes up. Just rerun the commercial flight/private jet scenario again. In this case, though, it's the regulator flying to a meeting with a corporate exec, and its the government picking up the cost. What do you think the government employee will pick, left to their own devices: crammed into coach, or flying in luxury on the private jet?