Principal-Agent Problem definition

Also known as the agency dilemma, the principal-agent problem refers to the inherent difficulties involved in motivating one party (the agent) to act in the best interests of another party (the principal) rather than in their own interest.

In an organisational context, the principal-agent problem concerns how the company encourages leaders and employees to make decisions in the interests of the company’s progression rather than in their own progression.

It’s important to note that the agent’s interests are not always self-interest – the principal-agent problem can, for example, cover whistleblowing, where the organisation will want the individual to refrain from whistleblowing while the individual’s moral compass may be encouraging them to highlight the wrongdoing.

To encourage agents to act in the principal’s interests, organisations use incentives such as profit sharing, promotions and target-based remuneration. Employment contracts themselves are concerned with aligning the goals and needs of employee and employer to mitigate the principal-agent problem as early as possible. Customised employment (CE) can further help to mitigate the issue.

The most difficult situations occur when potential consequences are beneficial to the principal but hazardous to the agent – in this case the principal may offer further information and incentive to encourage the agent to make the ‘right’ decision.