Black’s Law Dictionary (1999) defines a principal as someone “who authorizes another to act on his or her behalf as an agent.” The principal-agent relationship appears in many contexts. An employee acts on behalf of an employer in the sense that the employer receives certain benefits from the employee’s actions. Less obviously, there is a principal-agent relationship between an insurance company and an insuree, in the sense that the insurer’s actions subsequent to the insurance affect the principal, in effect, via payouts.
In economics, principal-agent problems generally refer to the analysis of contracts between individuals in which the individuals have conflicting goals and where asymmetric information is present. The labor contract is a classic example. A firm, when hiring a worker, wants maximum effort from the worker, whereas in many cases the worker prefers not to perform at the maximum level. If the contract between the two provides a fixed wage independent of the effort of the worker, then the worker has no incentive to work hard. The obvious solution is to make the wage depend on the worker’s effort. However, it is often the case that the relevant behavior is unobservable. While one can in principle identify the effort of an isolated worker who is producing objects, one cannot do this in more complicated environments, such as those in which many factors interact to determine output. This example illustrates some of the basic issues that exist in designing contracts in modern economies; namely, the dependence of the payoffs of the participants in a contract on the behaviors of others when these behaviors cannot be observed and can only be enforced by the terms of the contract.
This example of a principal-agent problem has focused on questions of hidden actions; that is, one agent takes an action that is unobservable to another, which affects the benefits to the contract between them. Other principal-agent models focus on the question of hidden information, in which one agent must reveal information to another in order to determine actions under the contract. The classic example of this problem concerns the writing of a contract when the disutility of a job is unknown. If the compensation a worker receives is increasing in the disutility he or she experiences, then he or she will have an incentive to claim the job is unpleasant regardless of the truth.
The analysis of principal-agent problems has led to a large number of substantive insights. For example, insurance deductibles can be understood as a way to create incentives for insurees to avoid overuse of medical care for which they are covered. These models have also been used to understand how landowners structure sharecropper contracts to elicit effort from tenants. The general problem is to structure the contract to obtain maximum expected utility for the principal subject to a constraint that the agent receives some prespecified level of utility. In their 1983 article Sanford Grossman and Oliver Hart discussed the design of optimal incentive schemes in this setting. Roy Radner demonstrated how the principal can improve design of optimal contracts by exploiting information gleaned in a repeated game setting. William Brock and Lewis Evans showed how continuous record asymptotics can be used to uncover hidden actions by agents.
Joseph Stiglitz pioneered a number of the ideas in the principal-agent literature. His Nobel Prize lecture “Information and the Change in Paradigm in Economics” (2002) is an enlightening summary of his thought. Other leading writers in this area include Grossman, Hart, Bengt Holmstrom, Paul Milgrom, James Mirrlees, Roger Myerson, Radner, and Stephen Ross; Ross’s 1973 article is an early explicit use of the terms principals and agents in modern economic theory. The contemporary theory of principal-agent models is well surveyed in Andreu MasCollel, Michael Whinston, and Jerry Green’s book Microeconomic Theory (1995).
SEE ALSO Information, Asymmetric; Information, Economics of; Mechanism Design
Black’s Law Dictionary. 1999. 7th ed. St. Paul, MN: West Group.
Brock, William, and Lewis Evans. Principal-Agent Contracts in Continuous Time Asymmetric Information Models: The Importance of Large Continuing Information Flows. Journal of Economic Behavior and Organization 29: 523–535.
Grossman, Sanford, and Oliver Hart. 1983. An Analysis of the Principal-Agent Problem. Econometrica 51: 7–45.
Radner, Roy. 1985. Repeated Principal-Agent Games with Discounting. Econometrica. 53: 1173–1198.
Ross, Stephen. 1973. The Economic Theory of Agency: The Principal’s Problem. American Economic Review 63: 134–139.
Stiglitz, Joseph. 2002. Information and the Change in Paradigm in Economics. In Les Prix Nobel; The Nobel Prizes 2001, ed. Tore Frangsmyr, 472–540. Stockholm: The Nobel Foundation.
William A. Brock
Steven N. Durlauf