Principal-Agent Problem in Economics: Definition & Examples

Instructor: Brianna Whiting
In this lesson, we will learn about the principal-agent problem in economics. We will define the term and look at some examples to better explain the concept before concluding with a summary and a quiz.

A First Look at the Principal-Agent Problem

Hopefully, many of us will never need the services of a lawyer. However, should that time arise, it entails quite a bit of research to find the perfect one. You want an attorney who specializes in your particular issue and has a great track record. Additionally, you'll want to seek out a lawyer who you can trust and who will work in your best interest. When there's a conflict between the lawyer's actions and the client's best interest, it is an example of what is called a principal-agent problem, which will be the focus of this lesson.

In terms of the principal-agent problem, the client and his or her legal problems represent the principal, whereas the lawyer is the agent. This type of relationship exists in a vast array of settings and is particularly relevant to political science and economics.

Further Exploration Into the Principal-Agent Problem

Let's go ahead and define this term further. In order to encounter a principal-agent problem, first an agent has to agree to work for, and in the best interest, of the principal in return for an incentive. Next, there must arise a problem with the relationship. Sometimes, the agent encounters costs that cause a conflict of interest, and these costs may then encourage the agent to work in his or her own best interest and ignore what is best for the principal.

Also, since the agent has full burden of completing the task commissioned, the agent may feel that he or she is not receiving fair benefits or compensation for the effort expended. This can lead to reduced motivation on part of the agent to work in the best interest of the principal and, in turn, a lack of effort.

Let's return to our earlier lawyer-client example. When you hire a lawyer, you trust that he or she will work as your agent and keep your best interest as the center focus. However, if that lawyer soon realizes that it will cost extra hours in the office in order to win your case, he or she may decide to go play golf instead. This would lead to a principal-agent problem, because the lawyer, or agent, did not fulfill his or her end of the relationship by deciding not to put in the required work for you, the principal.

Another Example of the Principal-Agent Problem

The following is an example of a scenario that might lead to a principal-agent problem:

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