Principal/Agent Problem

Sometimes people may want to delegate certain tasks to other individuals that are better positioned to perform the activities. For example the owner (principal) of a company may hire a professional management (agent) to control and lead the activities of the company. But the principal cannot fully observe the activities of the agent. Rather the principal observes the outcome of the activities of the agent. This lack of sufficient information about the activities of the agent on the part of the principal may induce the agent to behave in a way that undermines the interests of the principal. This problem is called principal-agent problem and may lead to inefficiency from the perspective of the owner.

For instance the objective function of the owners of a company might be to maximize profit but the managers might pursue extra objectives like building their own prestige at the expense of some profitability. As a result the enterprise may not perform in a way the owners would like it to do. The same problem arises between the management and workers. The management would like a worker to exert the maximum possible effort so as to produce as much output as possible but it is difficult for the management to monitor the activities of each and every worker. As a result the worker may want to focus on maximizing personal satisfaction at some expense of productivity.