Principal–agent problem

The principal–agent problem, in political science and

economics (also known as agency dilemma or the agency
problem) occurs when one person or entity (the "agent"), is
able to make decisions and/or take actions on behalf of, or
that impact, another person or entity: the "principal".[1] This
dilemma exists in circumstances where agents are motivated
to act in their own best interests, which are contrary to those
of their principals, and is an example of moral hazard.

Common examples of this relationship include corporate

management (agent) and shareholders (principal), elected
officials (agent) and citizens (principal), or brokers (agent)
and markets (buyers and sellers, principals).[2] Consider a
Basic idea of agency theory (P: principal, A: agent)
legal client (the principal) wondering whether their lawyer
(the agent) is recommending protracted legal proceedings
because it is truly necessary for the client's well being, or because it will generate income for the lawyer. In fact the problem can
arise in almost any context where one party is being paid by another to do something where the agent has a small or nonexistent
share in the outcome, whether in formal employment or a negotiated deal such as paying for household jobs or car repairs.

The problem arises where the two parties have different interests and asymmetric information (the agent having more
information), such that the principal cannot directly ensure that the agent is always acting in their (the principal's) best interest,[3]
particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are
costly for the principal to observe (see moral hazard and conflict of interest). Often, the principal may be sufficiently concerned at
the possibility of being exploited by the agent that they choose not to enter into the transaction at all, when it would have been
mutually beneficial: a suboptimal outcome that can lower welfare overall. The deviation from the principal's interest by the agent
is called "agency costs".[3]

The agency problem can be intensified when an agent acts on behalf of multiple principals (see multiple principal problem).[4]
When one agent acts on behalf of multiple principals, the multiple principals have to agree on the agent's objectives, but face a
collective action problem in governance, as individual principals may lobby the agent or otherwise act in their individual interests
rather than in the collective interest of all principals.[5] As a result, there may be free-riding in steering and monitoring,[6]
duplicate steering and monitoring,[7] or conflict between principals,[8] all leading to high autonomy for the agent. This has been
coined the multiple principal problem and is a serious problem in particularly the public sector, where multiple principals are
common and both efficiency and democratic accountability are undermined in the absence of salient governance.[4][9][10] This
problem may occur, for example, in the governance of the executive power, ministries, agencies, intermunicipal cooperation,
public-private partnerships, and firms with multiple shareholders.[4]

Various mechanisms may be used to align the interests of the agent with those of the principal. In employment, employers
(principal) may use piece rates/commissions, profit sharing, efficiency wages, performance measurement (including financial
statements), the agent posting a bond, or the threat of termination of employment to align worker interests with their own.

Contents
 Overview
Employment contract
Non-financial compensation
Team production
Empirical evidence
Contract design
Linear model
Options framework
Performance evaluation
Objective performance evaluation
Subjective performance evaluation
Incentive structures
Tournaments
Deferred compensation
Other applications
Energy consumption
Personnel management
Public officials
Trust relationships
Economic theory
Principal-Agent problem in negotiations
See also
References
Further reading
External links

Overview
The principal and agent theory emerged in the 1970s from the combined disciplines of economics and institutional theory. There
is some contention as to who originated the theory, with theorists Stephen Ross and Barry Mitnick claiming its authorship.[11]
Ross is said to have originally described the dilemma in terms of a person choosing a flavor of ice-cream for someone whose
tastes he does not know (Ibid). The most cited reference to the theory, however, comes from Michael C. Jensen and William
Meckling.[12] The theory has come to extend well beyond economics or institutional studies to all contexts of information
asymmetry, uncertainty and risk.

In the context of law, principals do not know enough about whether (or to what extent) a contract has been satisfied, and they end
up with agency costs. The solution to this information problem—closely related to the moral hazard problem—is to ensure the
provision of appropriate incentives so agents act in the way principals wish.

In terms of game theory, it involves changing the rules of the game so that the self-interested rational choices of the agent
coincide with what the principal desires. Even in the limited arena of employment contracts, the difficulty of doing this in practice
is reflected in a multitude of compensation mechanisms and supervisory schemes, as well as in critique of such mechanisms as
e.g., Deming (1986) expresses in his Seven Deadly Diseases of management.

Employment contract
In the context of the employment contract, individual contracts form a major method of restructuring incentives, by connecting as
closely as is optimal the information available about employee performance, and the compensation for that performance. Because
of differences in the quantity and quality of information available about the performance of individual employees, the ability of
employees to bear risk, and the ability of employees to manipulate evaluation methods, the structural details of individual
contracts vary widely, including such mechanisms as "piece rates, [share] options, discretionary bonuses, promotions, profit
sharing, efficiency wages, deferred compensation, and so on."[13] Typically, these mechanisms are used in the context of different
types of employment: salesmen often receive some or all of their remuneration as commission, production workers are usually
paid an hourly wage, while office workers are typically paid monthly or semimonthly (and if paid overtime, typically at a higher
rate than the hourly rate implied by the salary). The way in which these mechanisms are used is different in the two parts of the
economy which Doeringer and Piore called the "primary" and "secondary" sectors (see also dual labour market).

The secondary sector is characterised by short-term employment relationships, little or no prospect of internal promotion, and the
determination of wages primarily by market forces. In terms of occupations, it consists primarily of low or unskilled jobs,
whether they are blue-collar (manual-labour), white-collar (e.g., filing clerks), or service jobs (e.g., waiters). These jobs are
linked by the fact that they are characterized by "low skill levels, low earnings, easy entry, job impermanence, and low returns to
education or experience." In a number of service jobs, such as food service, golf caddying, and valet parking jobs, workers in
some countries are paid mostly or entirely with tips.

The use of tipping is a strategy on the part of the owners or managers to align the interests of the service workers with those of
the owners or managers; the service workers have an incentive to provide good customer service (thus benefiting the company's
business), because this makes it more likely that they will get a good tip.

The issue of tipping is sometimes discussed in connection with the principal–agent theory. "Examples of principals and agents
include bosses and employees ... [and] diners and waiters." "The "principal–agent problem", as it is known in economics, crops
up any time agents aren't inclined to do what principals want them to do. To sway them [(agents)], principals have to make it
worth the agents' while ... [in the restaurant context,] the better the diner's experience, the bigger the waiter's tip."[14] "In the ...
language of the economist, the tip serves as a way to reduce what is known as the classic "principal–agent" problem." According
to "Videbeck, a researcher at the New Zealand Institute for the Study of Competition and Regulation[,] '[i]n theory, tipping can
lead to an efficient match between workers' attitudes to service and the jobs they perform. It is a means to make people work
hard. Friendly waiters will go that extra mile, earn their tip, and earn a relatively high income...[On the other hand,] if tipless
wages are sufficiently low, then grumpy waiters might actually choose to leave the industry and take jobs that would better suit
their personalities.'"[15]

As a solution to the principal–agent problem, though, tipping is not perfect. In the hopes of getting a larger tip, a server, for
example, may be inclined to give a customer an extra large glass of wine or a second scoop of ice cream. While these larger
servings make the customer happy and increase the likelihood of the server getting a good tip, they cut into the profit margin of
the restaurant. In addition, a server may dote on generous tippers while ignoring other customers, and in rare cases harangue bad
tippers.

Non-financial compensation
Part of this variation in incentive structures and supervisory mechanisms may be attributable to variation in the level of intrinsic
psychological satisfaction to be had from different types of work. Sociologists and psychologists frequently argue that individuals
take a certain degree of pride in their work, and that introducing performance-related pay can destroy this "psycho-social
compensation", because the exchange relation between employer and employee becomes much more narrowly economic,
destroying most or all of the potential for social exchange. Evidence for this is inconclusive—Deci (1971), and Lepper, Greene
and Nisbett (1973) find support for this argument; Staw (1989) suggests other interpretations of the findings.
Team production
On a related note, Drago and Garvey (1997) use Australian survey data to show that when agents are placed on individual pay-
for-performance schemes, they are less likely to help their coworkers. This negative effect is particularly important in those jobs
that involve strong elements of "team production" (Alchian and Demsetz 1972), where output reflects the contribution of many
individuals, and individual contributions cannot be easily identified, and compensation is therefore based largely on the output of
the team. In other words, pay-for-performance increases the incentives to free-ride, as there are large positive externalities to the
efforts of an individual team member, and low returns to the individual (Holmström 1982, McLaughlin 1994).

The negative incentive effects implied are confirmed by some empirical studies, (e.g., Newhouse, 1973) for shared medical
practices; costs rise and doctors work fewer hours as more revenue is shared. Leibowitz and Tollison (1980) find that larger law
partnerships typically result in worse cost containment. As a counter, peer pressure can potentially solve the problem (Kandel and
Lazear 1992), but this depends on peer monitoring being relatively costless to the individuals doing the monitoring/censuring in
any particular instance (unless one brings in social considerations of norms and group identity and so on). Studies suggest that
profit-sharing, for example, typically raises productivity by 3–5% (Jones and Kato 1995, Knez and Simester 2001), although
there are some selection issues (Prendergast).

Empirical evidence
There is however considerable empirical evidence of a positive effect of compensation on performance (although the studies
usually involve "simple" jobs where aggregate measures of performance are available, which is where piece rates should be most
effective). In one study, Lazear (1996) saw productivity rising by 44% (and wages by 10%) in a change from salary to piece rates,
with a half of the productivity gain due to worker selection effects. Research shows that pay for performance increases
performance when the task at hand is more repetitive, and reduces performance when the task at hand requires more creative
thinking.[16]

Paarsch and Shearer (1996) also find evidence supportive of incentive and productivity effects from piece rates,
as do Banker, Lee, and Potter (1996), although the latter do not distinguish between incentive and worker
selection effects.
Rutherford, Springer and Yavas (2005) find evidence of agency problems in residential real estate by showing
that real estate agents sell their own houses at a price premium of approximately 4.5% compared to their clients'
houses.
Fernie and Metcalf (1996) find that top British jockeys perform significantly better when offered percentage of
prize money for winning races compared to being on fixed retainers.
McMillan, Whalley and Zhu (1989) and Groves et al. (1994) look at Chinese agricultural and industrial data
respectively and find significant incentive effects.
Kahn and Sherer (1990) find that better evaluations of white-collar office workers were achieved by those
employees who had a steeper relation between evaluations and pay.
Nikkinen and Sahlström (2004) find empirical evidence that agency theory can be used, at least to some extent,
to explain financial audit fees internationally.
There is very little correlation between performance pay of CEOs and the success of the companies they
manage.[17]

Contract design
Milgrom and Roberts (1992) identify four principles of contract design: When perfect information is not available, Holmström
(1979) developed the Informativeness Principle to solve this problem. This essentially states that any measure of performance
that (on the margin) reveals information about the effort level chosen by the agent should be included in the compensation
contract. This includes, for example, Relative Performance Evaluation—measurement relative to other, similar agents, so as to
filter out some common background noise factors, such as fluctuations in demand. By removing some exogenous sources of
randomness in the agent's income, a greater proportion of the fluctuation in the agent's income falls under his control, increasing
his ability to bear risk. If taken advantage of, by greater use of piece rates, this should improve incentives. (In terms of the simple
linear model below, this means that increasing x produces an increase in b.)

However, setting incentives as intense as possible is not necessarily optimal from the point of view of the employer. The
Incentive-Intensity Principle states that the optimal intensity of incentives depends on four factors: the incremental profits
created by additional effort, the precision with which the desired activities are assessed, the agent's risk tolerance, and the agent's
responsiveness to incentives. According to Prendergast (1999, 8), "the primary constraint on [performance-related pay] is that
[its] provision imposes additional risk on workers ..." A typical result of the early principal–agent literature was that piece rates
tend to 100% (of the compensation package) as the worker becomes more able to handle risk, as this ensures that workers fully
internalize the consequences of their costly actions. In incentive terms, where we conceive of workers as self-interested rational
individuals who provide costly effort (in the most general sense of the worker's input to the firm's production function), the more
compensation varies with effort, the better the incentives for the worker to produce.

The third principle—the Monitoring Intensity Principle—is complementary to the second, in that situations in which the
optimal intensity of incentives is high corresponds highly to situations in which the optimal level of monitoring is also high. Thus
employers effectively choose from a "menu" of monitoring/incentive intensities. This is because monitoring is a costly means of
reducing the variance of employee performance, which makes more difference to profits in the kinds of situations where it is also
optimal to make incentives intense.

The fourth principle is the Equal Compensation Principle, which essentially states that activities equally valued by the
employer should be equally valuable (in terms of compensation, including non-financial aspects such as pleasantness of the
workplace) to the employee. This relates to the problem that employees may be engaged in several activities, and if some of these
are not monitored or are monitored less heavily, these will be neglected, as activities with higher marginal returns to the employee
are favoured. This can be thought of as a kind of "disintermediation"—targeting certain measurable variables may cause others to
suffer. For example, teachers being rewarded by test scores of their students are likely to tend more towards teaching 'for the test',
and de-emphasise less relevant but perhaps equally or more important aspects of education; while AT&T's practice at one time of
paying programmers by the number of lines of code written resulted in programs that were longer than necessary—i.e., program
efficiency suffering (Prendergast 1999, 21). Following Holmström and Milgrom (1990) and Baker (1992), this has become
known as "multi-tasking" (where a subset of relevant tasks is rewarded, non-rewarded tasks suffer relative neglect). Because of
this, the more difficult it is to completely specify and measure the variables on which reward is to be conditioned, the less likely
that performance-related pay will be used: "in essence, complex jobs will typically not be evaluated through explicit contracts."
(Prendergast 1999, 9).

Where explicit measures are used, they are more likely to be some kind of aggregate measure, for example, baseball and
American Football players are rarely rewarded on the many specific measures available (e.g., number of home runs), but
frequently receive bonuses for aggregate performance measures such as Most Valuable Player. The alternative to objective
measures is subjective performance evaluation, typically by supervisors. However, there is here a similar effect to "multi-
tasking", as workers shift effort from that subset of tasks which they consider useful and constructive, to that subset which they
think gives the greatest appearance of being useful and constructive, and more generally to try to curry personal favour with
supervisors. (One can interpret this as a destruction of organizational social capital—workers identifying with, and actively
working for the benefit of, the firm – in favour of the creation of personal social capital—the individual-level social relations
which enable workers to get ahead ("networking").)

Linear model
The four principles can be summarized in terms of the simplest (linear) model of incentive compensation:
where w (wage) is equal to a (the base salary) plus b (the intensity of incentives provided to the employee) times the sum of three
terms: e (unobserved employee effort) plus x (unobserved exogenous effects on outcomes) plus the product of g (the weight given
to observed exogenous effects on outcomes) and y (observed exogenous effects on outcomes). b is the slope of the relationship
between compensation and outcomes.

The above discussion on explicit measures assumed that contracts would create the linear incentive structures summarised in the
model above. But while the combination of normal errors and the absence of income effects yields linear contracts, many
observed contracts are nonlinear. To some extent this is due to income effects as workers rise up a tournament/hierarchy: "Quite
simply, it may take more money to induce effort from the rich than from the less well off." (Prendergast 1999, 50). Similarly, the
threat of being fired creates a nonlinearity in wages earned versus performance. Moreover, many empirical studies illustrate
inefficient behaviour arising from nonlinear objective performance measures, or measures over the course of a long period (e.g., a
year), which create nonlinearities in time due to discounting behaviour. This inefficient behaviour arises because incentive
structures are varying: for example, when a worker has already exceeded a quota or has no hope of reaching it, versus being close
to reaching it—e.g., Healy (1985), Oyer (1997), Leventis (1997). Leventis shows that New York surgeons, penalised for
exceeding a certain mortality rate, take less risky cases as they approach the threshold. Courty and Marshke (1997) provide
evidence on incentive contracts offered to agencies, which receive bonuses on reaching a quota of graduated trainees within a
year. This causes them to 'rush-graduate' trainees in order to make the quota.

Options framework
In certain cases agency problems may be analysed by applying the techniques developed for financial options, as applied via a
real options framework.[18][19] Stockholders and bondholders have different objective—for instance, stockholders have an
incentive to take riskier projects than bondholders do, and to pay more out in dividends than bondholders would like. At the same
time, since equity may be seen as a call option on the value of the firm, an increase in the variance in the firm value, other things
remaining equal, will lead to an increase in the value of equity, and stockholders may therefore take risky projects with negative
net present values, which while making them better off, may make the bondholders worse off. See Option pricing approaches
under Business valuation for further discussion. Nagel and Purnanandam (2017) notice that since bank assets are risky debt
claims, bank equity resembles a subordinated debt and therefore the stock's payoff is truncated by the difference between the face
values of the corporation debt and of the bank deposits.[20] Based on this observation, Peleg-Lazar and Raviv (2017) show that in
contrast to the classical agent theory of Michael C. Jensen and William Meckling, an increase in variance would not lead to an
increase in the value of equity if the bank's debtor is solvent.[21]

Performance evaluation

Objective performance evaluation

The major problem in measuring employee performance in cases where it is difficult to draw a straightforward connection
between performance and profitability is the setting of a standard by which to judge the performance. One method of setting an
absolute objective performance standard—rarely used because it is costly and only appropriate for simple repetitive tasks—is
time-and-motion studies, which study in detail how fast it is possible to do a certain task. These have been used constructively in
the past, particularly in manufacturing. More generally, however, even within the field of objective performance evaluation, some
form of relative performance evaluation must be used. Typically this takes the form of comparing the performance of a worker to
that of his peers in the firm or industry, perhaps taking account of different exogenous circumstances affecting that.

The reason that employees are often paid according to hours of work rather than by direct measurement of results is that it is often
more efficient to use indirect systems of controlling the quantity and quality of effort, due to a variety of informational and other
issues (e.g., turnover costs, which determine the optimal minimum length of relationship between firm and employee). This
means that methods such as deferred compensation and structures such as tournaments are often more suitable to create the
incentives for employees to contribute what they can to output over longer periods (years rather than hours). These represent
"pay-for-performance" systems in a looser, more extended sense, as workers who consistently work harder and better are more
likely to be promoted (and usually paid more), compared to the narrow definition of "pay-for-performance", such as piece rates.
This discussion has been conducted almost entirely for self-interested rational individuals. In practice, however, the incentive
mechanisms which successful firms use take account of the socio-cultural context they are embedded in (Fukuyama 1995,
Granovetter 1985), in order not to destroy the social capital they might more constructively mobilise towards building an organic,
social organization, with the attendant benefits from such things as "worker loyalty and pride (...) [which] can be critical to a
firm's success ..." (Sappington 1991,63)

Subjective performance evaluation

Subjectivity is related to judgement based on a supervisor's subjective impressions and opinions, which can be expressed through
the use of subjective performance measures, ex post flexibility in the weighting of objective performance measures, or ex post
discretional adjustment, all of which are based on factors other than performance measures specified ex ante.[22] Subjective
performance evaluation allows the use of a subtler, more balanced assessment of employee performance, and is typically used for
more complex jobs where comprehensive objective measures are difficult to specify and/or measure. Whilst often the only
feasible method, the attendant problems with subjective performance evaluation have resulted in a variety of incentive structures
and supervisory schemes. One problem, for example, is that supervisors may under-report performance in order to save on wages,
if they are in some way residual claimants, or perhaps rewarded on the basis of cost savings. This tendency is of course to some
extent offset by the danger of retaliation and/or demotivation of the employee, if the supervisor is responsible for that employee's
output.

Another problem relates to what is known as the "compression of ratings". Two related influences—centrality bias, and leniency
bias—have been documented (Landy and Farr 1980, Murphy and Cleveland 1991). The former results from supervisors being
reluctant to distinguish critically between workers (perhaps for fear of destroying team spirit), while the latter derives from
supervisors being averse to offering poor ratings to subordinates, especially where these ratings are used to determine pay, not
least because bad evaluations may be demotivating rather than motivating. However, these biases introduce noise into the
relationship between pay and effort, reducing the incentive effect of performance-related pay. Milkovich and Wigdor (1991)
suggest that this is the reason for the common separation of evaluations and pay, with evaluations primarily used to allocate
training.

Finally, while the problem of compression of ratings originates on the supervisor-side, related effects occur when workers
actively attempt to influence the appraisals supervisors give, either by influencing the performance information going to the
supervisor: multitasking (focussing on the more visibly productive activities—Paul 1992), or by working "too hard" to signal
worker quality or create a good impression (Holmström 1982); or by influencing the evaluation of it, e.g., by "currying influence"
(Milgrom and Roberts 1988) or by outright bribery (Tirole 1992).

Incentive structures
Tournaments
Much of the discussion here has been in terms of individual pay-for-performance contracts; but many large firms use internal
labour markets (Doeringer and Piore 1971, Rosen 1982) as a solution to some of the problems outlined. Here, there is "pay-for-
performance" in a looser sense over a longer time period. There is little variation in pay within grades, and pay increases come
with changes in job or job title (Gibbs and Hendricks 1996). The incentive effects of this structure are dealt with in what is known
as "tournament theory" (Lazear and Rosen 1981, Green and Stokey (1983), see Rosen (1986) for multi-stage tournaments in
hierarchies where it is explained why CEOs are paid many times more than other workers in the firm). See the superstar article
for more information on the tournament theory.

Workers are motivated to supply effort by the wage increase they would earn if they win a promotion. Some of the extended
tournament models predict that relatively weaker agents, be they competing in a sports tournaments (Becker and Huselid 1992, in
NASCAR racing) or in the broiler chicken industry (Knoeber and Thurman 1994), would take risky actions instead of increasing
their effort supply as a cheap way to improve the prospects of winning. These actions are inefficient as they increase risk taking
without increasing the average effort supplied.

A major problem with tournaments is that individuals are rewarded based on how well they do relative to others. Co-workers
might become reluctant to help out others and might even sabotage others' effort instead of increasing their own effort (Lazear
1989, Rob and Zemsky 1997). This is supported empirically by Drago and Garvey (1997). Why then are tournaments so popular?
Firstly, because—especially given compression rating problems—it is difficult to determine absolutely differences in worker
performance. Tournaments merely require rank order evaluation. Secondly, it reduces the danger of rent-seeking, because bonuses
paid to favourite workers are tied to increased responsibilities in new jobs, and supervisors will suffer if they do not promote the
most qualified person. Thirdly, where prize structures are (relatively) fixed, it reduces the possibility of the firm reneging on
paying wages. As Carmichael (1983) notes, a prize structure represents a degree of commitment, both to absolute and to relative
wage levels. Lastly when the measurement of workers' productivity is difficult, e.g., say monitoring is costly, or when the tasks
the workers have to perform for the job is varied in nature, making it hard to measure effort and/or performance, then running
tournaments in a firm would encourage the workers to supply effort whereas workers would have shirked if there are no
promotions.

Tournaments also promote risk seeking behavior. In essence, the compensation scheme becomes more like a call option on
performance (which increases in value with increased volatility (cf. options pricing). If you are one of ten players competing for
the asymmetrically large top prize, you may benefit from reducing the expected value of your overall performance to the firm in
order to increase your chance that you have an outstanding performance (and win the prize). In moderation this can offset the
greater risk aversion of agents vs principals because their social capital is concentrated in their employer while in the case of
public companies the principal typically owns his stake as part of a diversified portfolio. Successful innovation is particularly
dependent on employees' willingness to take risks. In cases with extreme incentive intensity, this sort of behavior can create
catastrophic organizational failure. If the principal owns the firm as part of a diversified portfolio this may be a price worth
paying for the greater chance of success through innovation elsewhere in the portfolio. If however the risks taken are systematic
and cannot be diversified e.g., exposure to general housing prices, then such failures will damage the interests of principals and
even the economy as a whole. (cf. Kidder Peabody, Barings, Enron, AIG to name a few). Ongoing periodic catastrophic
organizational failure is directly incentivized by tournament and other superstar/winner-take-all compensation systems (Holt
1995).

Deferred compensation
Tournaments represent one way of implementing the general principle of "deferred compensation", which is essentially an
agreement between worker and firm to commit to each other. Under schemes of deferred compensation, workers are overpaid
when old, at the cost of being underpaid when young. Salop and Salop (1976) argue that this derives from the need to attract
workers more likely to stay at the firm for longer periods, since turnover is costly. Alternatively, delays in evaluating the
performance of workers may lead to compensation being weighted to later periods, when better and poorer workers have to a
greater extent been distinguished. (Workers may even prefer to have wages increasing over time, perhaps as a method of forced
saving, or as an indicator of personal development. e.g., Loewenstein and Sicherman 1991, Frank and Hutchens 1993.) For
example, Akerlof and Katz 1989: if older workers receive efficiency wages, younger workers may be prepared to work for less in
order to receive those later. Overall, the evidence suggests the use of deferred compensation (e.g., Freeman and Medoff 1984, and
Spilerman 1986—seniority provisions are often included in pay, promotion and retention decisions, irrespective of productivity.)

Other applications

Energy consumption
The "principal–agent problem" has also been discussed in the context of energy consumption by Jaffe and Stavins in 1994. They
were attempting to catalog market and non-market barriers to energy efficiency adoption. In efficiency terms, a market failure
arises when a technology which is both cost-effective and saves energy is not implemented. Jaffe and Stavins describe the
common case of the landlord-tenant problem with energy issues as a principal–agent problem. "[I]f the potential adopter is not the
party that pays the energy bill, then good information in the hands of the potential adopter may not be sufficient for optimal
diffusion; adoption will only occur if the adopter can recover the investment from the party that enjoys the energy savings. Thus,
if it is difficult for the possessor of information to convey it credibly to the party that benefits from reduced energy use, a
principal/agent problem arises."[23]

The energy efficiency use of the principal agent terminology is in fact distinct from the usual one in several ways. In
landlord/tenant or more generally equipment-purchaser/energy-bill-payer situations, it is often difficult to describe who would be
the principal and who the agent. Is the agent the landlord and the principal the tenant, because the landlord is "hired" by the tenant
through the payment of rent? As Murtishaw and Sathaye, 2006 point out, "In the residential sector, the conceptual definition of
principal and agent must be stretched beyond a strictly literal definition."

Another distinction is that the principal agent problem in energy efficiency does not require any information asymmetry: both the
landlord and the tenant may be aware of the overall costs and benefits of energy-efficient investments, but as long as the landlord
pays for the equipment and the tenant pays the energy bills, the investment in new, energy-efficient appliances will not be made.
In this case, there is also little incentive for the tenant to make a capital efficiency investment with a usual payback time of
several years, and which in the end will revert to the landlord as property. Since energy consumption is determined both by
technology and by behavior, an opposite principal agent problem arises when the energy bills are paid by the landlord, leaving the
tenant with no incentive to moderate her energy use. This is often the case for leased office space, for example.

The energy efficiency principal agent problem applies in many cases to rented buildings and apartments, but arises in other
circumstances, most often involving relatively high up-front costs for energy-efficient technology. Though it is challenging to
assess exactly, the principal agent problem is considered to be a major barrier to the diffusion of efficient technologies. This can
be addressed in part by promoting shared-savings performance-based contracts, where both parties benefit from the efficiency
savings. The issues of market barriers to energy efficiency, and the principal agent problem in particular, are receiving renewed
attention because of the importance of global climate change and rising prices of the finite supply of fossil fuels. The principal–
agent problem in energy efficiency is the topic of an International Energy Agency report:[24] "Mind the Gap—Quantifying
Principal–Agent Problems in Energy Efficiency" (2007).

Personnel management
The problem manifests itself in the ways middle managers discriminate against employees who they deem to be "overqualified"
in hiring, assignment, and promotion, and repress or terminate "whistleblowers" who want to make senior management aware of
fraud or illegal activity. This may be done for the benefit of the middle manager and against the best interest of the shareholders
(or members of a non-profit organization).

Public officials
Public officials are agents, and people adopt constitutions and laws to try to manage the relationship, but officials may betray
their trust and allow themselves to be unduly influenced by lobby groups or they may abuse their authority and managerial
discretion by showing personal favoritism or bad faith by hiring an unqualified friend or by engaging in corruption or patronage,
such as selecting the firm of a friend or family member for a no-bid contract.

Trust relationships
The problem arises in client–attorney, probate executor, bankruptcy trustee, and other such relationships. In some rare cases,
attorneys who were entrusted with estate accounts with sizeable balances acted against the interests of the person who hired them
to act as their agent by embezzling the funds or "playing the market" with the client's money (with the goal of pocketing any
proceeds).

Economic theory
In economic theory, the principal-agent approach (also called agency theory) is part of the field contract theory.[25][26] In agency
theory, it is typically assumed that complete contracts can be written, an assumption also made in mechanism design theory.
Hence, there are no restrictions on the class of feasible contractual arrangements between principal and agent. Agency theory can
be subdivided in two categories: (1) In adverse selection models, the agent has private information about his type (say, his costs
of exerting effort or his valuation of a good) before the contract is written. (2) In moral hazard models, the agent becomes
privately informed after the contract is written. Hart and Holmström (1987) divide moral hazard models in the categories "hidden
action" (e.g., the agent chooses an unobservable effort level) and "hidden information" (e.g., the agent learns his valuation of a
good, which is modelled as a random draw by nature).[27] In hidden action models, there is a stochastic relationship between the
unobservable effort and the verifiable outcome (say, the principal's revenue), because otherwise the unobservability of the effort
would be meaningless. Typically, the principal makes a take-it-or-leave-it offer to the agent; i.e., the principal has all bargaining
power. In principal–agent models, the agent often gets a strictly positive rent (i.e. his payoff is larger than his reservation utility,
which he would get if no contract were written), which means that the principal faces agency costs. For example, in adverse
selection models the agent gets an information rent, while in hidden action models with a wealth-constrained agent the principal
must leave a limited-liability rent to the agent.[25] In order to reduce the agency costs, the principal typically induces a second-
best solution that differs from the socially optimal first-best solution (which would be attained if there were complete
information). If the agent had all bargaining power, the first-best solution would be achieved in adverse selection models with
one-sided private information as well as in hidden action models where the agent is wealth-constrained. Contract-theoretic
principal–agent models have been applied in various fields, including financial contracting,[28] regulation,[29] public
procurement,[30] monopolistic price-discrimination,[31] job design,[32] internal labor markets,[33] team production,[34] and many
others. From the cybernetics point of view, the Cultural Agency Theory arose in order to better understand the socio-cultural
nature of organisations and their behaviours.

Principal-Agent problem in negotiations

As it is impossible for a manager to attend all upcoming negotiations of the company, it is common practice to assign internal or
external negotiators to represent the negotiating company at the negotiation table. With the principal-agent-problem, two areas of
negotiation emerge:

(1) negotiations between the agent and the actual negotiating partner (negotiations at the table)
(2) internal negotiations, as between the agent and the principal (negotiations behind the table).[35]

In practice, there is often more than one principal within the company with whom the negotiator has to agree the contract terms.
Likewise, it is common to send several agents, i.e. several negotiators.

See also
Adverse selection
Autonomous agency theory
Contract theory
Control fraud
Cost overrun
Fiduciary
Honest services fraud
Multiple principal problem
Participative decision-making
Self-dealing
Structure and agency
The Market for Lemons
Trustee

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Further reading
Azfar, Omar (2007). "Chapter 8: Disrupting Corruption" (http://siteresources.worldbank.org/INTWBIGOVANTCO
R/Resources/DisruptingCorruption.pdf) (PDF). In Shah, Anwar (ed.). Performance Accountability and Combating
Corruption (https://openknowledge.worldbank.org/handle/10986/6732) (PDF and text). Public Sector Governance
and Accountability Series. Washington, D.C.: World Bank. doi:10.1596/978-0-8213-6941-8 (https://doi.org/10.159
6%2F978-0-8213-6941-8). ISBN 9780821369418.
Eisenhardt, K. (1989). "Agency theory: An assessment and review". Academy of Management Review. 14 (1):
57–74. doi:10.5465/amr.1989.4279003 (https://doi.org/10.5465%2Famr.1989.4279003). JSTOR 258191 (https://
www.jstor.org/stable/258191).
Green, J. R.; Stokey, N. L. (1983). "A Comparison of Tournaments and Contracts" (http://nrs.harvard.edu/urn-3:H
UL.InstRepos:3203644). Journal of Political Economy. 91 (3): 349–64. doi:10.1086/261153 (https://doi.org/10.10
86%2F261153). JSTOR 1837093 (https://www.jstor.org/stable/1837093).
Mind the Gap—Quantifying Principal–Agent Problems in Energy Efficiency (http://www.iea.org/publications/freep
ublications/publication/mind_the_gap.pdf) (PDF), IEA, 2007.
Laffont, Jean-Jacques and Martimort, David (2002). The Theory of Incentives: The Principal–Agent Model.
Princeton University Press.
Li, Hongxia (2011). "Capital Structure on Agency Costs in Chinese Listed Firms". International Journal of
Governance. 1 (2): 26–39.
Murtishaw, S.; Sathaye, J. (2006), Quantifying the Effect of the Principal–Agent Problem on US Residential Use
(https://web.archive.org/web/20110511120355/http://ies.lbl.gov/iespubs/59773Rev.pdf) (PDF) (Report), LBNL-
59773, archived from the original (http://ies.lbl.gov/iespubs/59773Rev.pdf) (PDF) on May 11, 2011.
Nikkinen, Jussi; Sahlström, Petri (2004). "Does agency theory provide a general framework for audit pricing?".
International Journal of Auditing. 8 (3): 253–262. doi:10.1111/j.1099-1123.2004.00094.x (https://doi.org/10.111
1%2Fj.1099-1123.2004.00094.x).
Rees, R., 1985. "The Theory of Principal and Agent—Part I". Bulletin of Economic Research, 37(1), 3–26
Rees, R., 1985. "The Theory of Principal and Agent—Part II". Bulletin of Economic Research, 37(2), 75–97
Rutherford, R. & Springer, T. & Yavas, A. (2005). Conflicts between Principals and Agents: Evidence from
Residential Brokerage. Journal of Financial Economics (76), 627–65.
Rosen, S. (1986). "Prizes and Incentives in Elimination Tournaments". American Economic Review. 76 (4): 701–
715. JSTOR 1806068 (https://www.jstor.org/stable/1806068).
Sappington, David E. M. (1991). "Incentives in Principal–Agent Relationships". Journal of Economic
Perspectives. 5 (2): 45–66. doi:10.1257/jep.5.2.45 (https://doi.org/10.1257%2Fjep.5.2.45). JSTOR 1942685 (http
s://www.jstor.org/stable/1942685).
Stiglitz, Joseph E. (1987). "Principal and agent", The New Palgrave: A Dictionary of Economics, v. 3, pp. 966–71.

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