The agency problem arises when one party delegates decisions to another party whose incentives are not perfectly aligned with the delegator’s interests. It becomes serious when the principal cannot fully observe the agent’s information, effort, or risk-taking.
Why It Happens
Three ingredients usually drive the problem:
- delegation of authority from principal to agent
- asymmetric information, so the principal cannot fully observe type or behavior
- incomplete contracts, so not every contingency can be specified and enforced in advance
Once those conditions hold, the agent may rationally choose actions that are good for the agent but not best for the principal.
Hidden Information And Hidden Action
Agency problems can arise before or after contracting.
Before contracting, the principal may face hidden information about the agent’s type or ability. After contracting, the principal may face hidden action, where the agent’s effort or risk choice cannot be perfectly monitored.
That is why adverse selection and moral hazard are closely related to the broader agency problem.
Common Examples
Examples include:
- managers using company resources in ways shareholders would not prefer
- borrowers taking on more risk after receiving a loan
- employees reducing effort when performance is hard to verify
- public officials pursuing political goals that differ from voter interests
Typical Responses
Principals try to reduce the problem through contracts, incentives, monitoring, reporting, reputational penalties, and governance rules. None of these is perfect, which is why agency problems remain central in economics and finance.