Definition of principal/agent problem
The problem of motivating one party (the agent) to act on behalf of another (the principal) is known as the principal-agent problem, or agency problem for short.
Agency problems arise in a variety of different contexts. For example, a lawyer is meant to act in the best interest of his or her client; managers act on behalf of shareholders; employees work for their employers; politicians represent their voters and so on.
Agency problems arise when the incentives between the agent and the principal are not perfectly aligned and conflicts of interest arise. As a result the agent may be tempted to act in his or her own interest rather the principal’s. Conflicts of interest are almost inevitable. For example, the agent bears the full cost of putting effort into the task delegated by the principal, but usually does not receive the full benefit that results from these efforts. This may create an incentive for the agent to put in less effort into the task than he or she would do if acting on his or her own behalf. Similarly, traders or managers may take on excessive risk if they enjoy the benefits of doing so (a high bonus in case of success), but not the costs (shareholders and lenders losing a lot of money in case of failure). This type of 'moral hazard' is particularly relevant to the banking and insurance industry, and arises because the agent’s actions that lead to the increase in risk are not publicly observable.
Why can the agent get away with not acting in the best interest of the principal? A first possible explanation is that the cost to the principal of removing or punishing the agent is too high relative to the benefit. For example, a politician may get away with corruption during his term in office because in some environments it may be too costly for dispersed voters to undertake actions to remove the politician from office. A second, more widely applicable, explanation is the presence of information asymmetry. Information asymmetry arises when one party (the agent) is better informed than the other (the principal). Information asymmetry makes it difficult or even impossible for principals to know whether the agent acts in their best interest, especially if crucial variables (such as the agent’s effort or competence) are unobservable. For example, if a company reports disappointing earnings figures then it may be difficult for shareholders to judge whether managers are to blame (incompetence or laziness) or whether the poor results are due to adverse factors beyond managers' control (economic recession, bad luck...).
How can agency costs be mitigated? Most mechanisms focus on aligning the incentives between the principal and the agent through carrots and sticks. Some mechanisms are aimed at reducing the degree of information asymmetry.
Examples of aligning the incentives include employee ownership schemes, executive stock options and profit sharing schemes - all carrots - and dismissal, or criminal prosecution of fraud - sticks.
Examples of reducing information assymmetry include the compulsory provision of company accounts; auditing and monitoring; and legal disclosure requirements.
The Enron scandal revealed in 2001 led to the bankruptcy of the Enron Corporation and the dissolution of Arthur Andersen. Many executives at Enron were indicted for a variety of charges and sent to prison. In the wake of the Enron scandal new legislation (such as the Sarbanes-Oxley Act of 2002) was issued to improve investor protection and to increase the accuracy of financial reporting for public companies.