Principal-Agent Problem
Course Outline
Principal-Agent Problem
Imagine yourself in this situation:
You take your car into the shop, where the mechanic tells you that you need a number of pricey repairs. Do you really need them? How do you know if the mechanic is right, or even telling the truth?
What you’re experiencing is a principal-agent problem, which can arise when the incentives of both parties are not aligned.
You want your car to get fixed. The mechanic is looking to make money. And you don’t have the information to know a good deal from a bad deal.
Of course, this is just one example. But the principal-agent problem shows up other places, too — whenever there’s a case of asymmetric information. In other words, whenever one party has more and better information than the other.
Check out this video to learn more about this “problem.” Can you think of creative ways to address this?
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Transcript
What is the principal-agent problem? The easiest way to teach this is with a quick example. Imagine taking your car into the shop for routine service, and the mechanic says you need a number of repairs. Do you really need them? The mechanic certainly knows more about the car repair than you do, but it's hard to tell whether he's correct, or even telling the truth. You certainly don't want to pay for repairs you don't need. This is an example of a principal-agent problem, and it can arise when the incentives of two parties in a transaction are not aligned. In the case of your car, you are the principal and the mechanic is your agent. Your incentive is to get your car fixed and not waste too much money. His incentive might be to get as much money out of you as possible. Given that he has more information about cars than you do, he can lie to charge more. In this case, there are conflicting incentives, and you don't have the information to know a good deal from a bad deal. Ideally, you would like to align the incentives of the mechanic with yours so you don't get swindled. That is, at least, in principle, how you can solve a principal-agent problem. But the principal-agent problem runs much deeper than just the rip-off.
The bigger problem is that the potential for rip-off means that a transaction may be less likely to occur in the first place. If you know the mechanic may recommend more service than is necessary, you might, for instance, pass on some recommended precautionary repairs and just wait until your car breaks down. Of course that can be inefficient. You'd prefer to perform that preventative maintenance and not break down unexpectedly. But you also can't trust your agent, the mechanic, and so you pass on those repairs for fear of being ripped off. It turns out the principal-agent problem usually arises when there is asymmetric information. That is, when one party in a transaction has more and better information than the other party. To learn more about problems resulting from asymmetric information, click here. Or, to test yourself on your understanding of the principal-agent problem, click here. Still here? Check out Marginal Revolution University's other popular economics videos.
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