Principal-Agent Problem

Weekly I/O#59

Principal-Agent problem occurs when one person hires another person to do a job but cannot fully monitor or control their actions, potentially leading to conflicts of interest or suboptimal outcomes.

Article: Moral Hazard: Definition, Meaning, Examples, and How to Manage

The principal-agent problem occurs when one party (the principal) hires another party (the agent) to carry out a task or make decisions, but the agent's incentives might not align with the principal's interests, leading to conflicts of interest and suboptimal outcomes.

For instance, a company's shareholders (the principals) hire a CEO (the agent) to manage the company. However, the CEO may have incentives misaligned with the shareholders' interests. The CEO may prioritize short-term profits over long-term growth because they receive bonuses tied only to the company's short-term performance. This misalignment incentivizes CEO to focus on their own interests rather than those of the shareholders.

Another example is a patient (the principal) hiring a doctor (the agent) to provide medical care. The doctor may have financial incentives to prescribe specific treatments, even if they are not in the best interests of the patient's health. This can lead to over-treatment or unnecessary procedures that may harm the patient.

In brief, don't ask a barber whether you need a haircut, and don't ask an investment banker whether you should go IPO. To mitigate the risks of the principal-agent problem, we need to consider Goodhart's Law in #56.1: "when a measure becomes a target, it ceases to be a good measure".

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