Question

5. What does the principal agent problem refer to,and what is an example of it? In your example, what is something that the agent might do that would conflict with the goals of the principal? What actionscould the principal take to try to prevent (or at least reduce) this problem?

Answer 1

Equity contracts such as stocks that are subject to a particular type of moral hazrd are called principal agent problem. this happens when the perosn who owns the firms or major stock is different from the person who manages it. this creates the problem of principal agent.

let us suppose A wants to invest in a store of icecream . but he has less of funds. suppose say 10% of the required . he lets his friend become a silent partner who invests the rest 90% . so A does all the work in the store from taking orders to cleaning and everything . but gets a profit of only the percentage share he has invested and the sleeping partner who had just invested the money gets major chunk of it without working hard. so A is not incentivised properly which would lead to lessening of efforts on his part.

the principal agent problem gets worse when A instead of working hard tends to be dishonest like showing less profits than they are, pocketing the rest .

the principal can reduce this problem when he has the complete information of what the agents could do and thus prevent fraud or wasteful acts . this is also an example of moral hazard where full information is not available.

such a problem could be solved by constant monitoring of the agent by the principal or through debt contracts where the amount paid to the principal is fixed via contract so it would be only concern of the principal . the rest of the profits could work as an incentive fro the agent and he can hence work towards it honestly.