Asymmetric Information in Principal-Agent Problems

Application: Non-Verifiable Information in Principal-Agent Problems

The Owner-Manager Relationship as a Principal-Agent Problem

Exercise: Evaluating Statements on the Principal-Agent Problem

Sales Incentive Structure

A homeowner hires a contractor to complete a major kitchen renovation. The homeowner wants the highest quality materials and craftsmanship to maximize their property value, while the contractor, who is paid a fixed price for the job, might be tempted to use slightly cheaper materials or faster techniques to increase their profit margin. What is the fundamental economic problem illustrated by this scenario?

Public Project Management Scenario

Analyzing the Doctor-Patient Relationship

A publicly-traded company's shareholders (the owners) hire a CEO to run the company. The shareholders want to maximize long-term stock value. The CEO, whose compensation is partly tied to annual profits, might be tempted to cut research and development (R&D) spending to boost short-term earnings, even if it harms the company's future growth. The shareholders cannot perfectly observe whether the CEO's R&D decisions are genuinely for the company's long-term good or are self-serving. Match each element from this scenario to its corresponding concept within the relevant economic framework.

The principal-agent problem ceases to exist if the principal can perfectly observe the agent's actions, even if that observation cannot be proven to a third party.

Incentive Structures and Unintended Consequences

A tech startup founder, who is not a programmer, hires a freelance developer on a fixed-fee contract to build a mobile app. The founder wants clean, maintainable code for future updates, but can only verify that the app functions as specified. The developer's incentive is to finish quickly to maximize their effective hourly earnings, potentially by writing messy code that is hard to maintain. Which of the following contract adjustments would be the least effective at aligning the incentives of the founder and the developer?

A conflict of interest can arise when one party (an agent) is hired to act on behalf of another (a principal). This conflict often becomes a significant economic problem when the principal cannot fully monitor or enforce the agent's actions due to an information gap. In which of the following situations is this specific type of problem LEAST likely to be a major concern?

Evaluating an Environmental Cleanup Contract

The Lender-Borrower Relationship as a Principal-Agent Problem

The Employer-Employee Relationship as a Principal-Agent Problem