What Is the Principal-Agent Problem?

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- [woman] What is
the principal-agent problem?

The easiest way to teach this
is with a quick example.

Imagine taking your car
into the shop for routine service,

and the mechanic says
you need a number of repairs.

Do you really need them?

The mechanic certainly knows more
about the car repair than you do,

but it's hard to tell
whether he's correct,

or even telling the truth.

You certainly don't want
to pay for repairs you don't need.

This is an example
of a principal-agent problem,

and it can arise when the incentives
of two parties in a transaction

are not aligned.

In the case of your car,

you are the principal
and the mechanic is your agent.

Your incentive is
to get your car fixed

and not waste too much money.

His incentive might be to get
as much money out of you as possible.

Given that he has more information
about cars than you do,

he can lie to charge more.

In this case,
there are conflicting incentives,

and you don't have the information
to know a good deal from a bad deal.

Ideally, you would like
to align the incentives

of the mechanic with yours
so you don't get swindled.

That is, at least, in principle,

how you can solve
a principal-agent problem.

But the principal-agent problem
runs much deeper

than just the rip-off.

The bigger problem is
that the potential for rip-off

means that a transaction
may be less likely to occur

in the first place.

If you know the mechanic
may recommend

more service than is necessary,
you might, for instance,

pass on some recommended
precautionary repairs

and just wait
until your car breaks down.

Of course that can be inefficient.

You'd prefer to perform
that preventative maintenance

and not break down unexpectedly.

But you also can't trust
your agent, the mechanic,

and so you pass on those repairs
for fear of being ripped off.

It turns out the principal-
agent problem usually arises

when there is
asymmetric information.

That is, when one party
in a transaction

has more and better information
than the other party.

To learn more about problems
resulting from asymmetric information,

click here.

Or, to test yourself
on your understanding

of the principal-
agent problem,click here.

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