When you hire someone (agent) to act on your behalf (principal), their interests may not align with yours. They know more than you, and you can't watch everything they do.
Relationship Parameters
How much more does the agent know than the principal?
How well can the principal observe the agent's actions?
How much of the agent's pay depends on principal's outcomes?
How much does the agent prefer safe options over risky ones?
One-time vs long-term relationship (affects reputation effects)
Behavior Divergence
Agent Likely To:
Agent Unlikely To:
The dynamic
Real-world examples
Fund Managers
Paid on assets under management, not returns. Incentive: gather assets, not outperform. Taking big risks could lose assets; safer to be mediocre.
Doctors (Fee-for-Service)
Paid per procedure. Incentive: more procedures, regardless of whether they help. Patient wants health; doctor's income tied to activity.
Real Estate Agents
Paid % of sale price, but their time is valuable. Incentive: close deals fast, not get you the best price. An extra $10K for you is only $300 for them.
CEOs (Quarterly Targets)
Compensated on short-term stock price and quarterly earnings. Incentive: pump short-term numbers, even at long-term cost. Shareholders want lasting value.
Mitigating the problem
Equity, profit sharing, skin in the game. Make agent's success depend on principal's success.
Better reporting, transparency, audits. Reduce information asymmetry.
Long vesting, deferred compensation. Make reputation matter more.
Choose agents with intrinsic motivation aligned with your goals. Culture fit matters.