Principal-Agent Problem
When decision rights are delegated, agents optimise their own payoff under information asymmetry. Without smart contracts and governance, effort, risk and horizon drift away from the principal’s goals.
author
Economics/contract theory (Jensen–Meckling; Akerlof; Holmström)
Model type
About
Any time owners (principals) rely on others (agents) to act for them, gaps appear: different objective functions, private information, hidden actions, different risk appetites and time horizons. Agency costs are the sum of monitoring, bonding, and residual loss.
How it works
Information asymmetry – agent knows more about effort, quality, or risk taken.
Moral hazard (hidden action) – unobservable effort/risk after the contract leads to shirking or risk-shifting.
Adverse selection (hidden info) – low-quality agents/projects select into rich contracts.
Horizon mismatch – short-term bonuses vs long-term firm value.
Risk-sharing – principals are diversified; agents are not → pay mix matters.
Multitasking & proxies – paying on one metric distorts the others (Goodhart effects).
Moral hazard (hidden action) – unobservable effort/risk after the contract leads to shirking or risk-shifting.
Adverse selection (hidden info) – low-quality agents/projects select into rich contracts.
Horizon mismatch – short-term bonuses vs long-term firm value.
Risk-sharing – principals are diversified; agents are not → pay mix matters.
Multitasking & proxies – paying on one metric distorts the others (Goodhart effects).
Use cases
Executive & sales compensation – equity/vesting, quota design, clawbacks.
Asset management – GP–LP fees, carry, high-water marks, hurdles.
Franchising & platforms – brand standards, audits, rating systems.
Outsourcing/procurement – SLAs, penalties/bonuses, termination rights.
Insurance & lending – deductibles, covenants, monitoring.
M&A integration – earn-outs, retention and founder handover risk.
Public sector – contractor incentives vs service quality; PPPs.
Asset management – GP–LP fees, carry, high-water marks, hurdles.
Franchising & platforms – brand standards, audits, rating systems.
Outsourcing/procurement – SLAs, penalties/bonuses, termination rights.
Insurance & lending – deductibles, covenants, monitoring.
M&A integration – earn-outs, retention and founder handover risk.
Public sector – contractor incentives vs service quality; PPPs.
How to apply
Define true objectives – the outcome you actually care about (not its proxy).
Map information gaps – what the agent knows/controls that you don’t.
Choose contract levers – pay mix β on results vs inputs, floors/caps, deferral, clawbacks.
Add screens & selection – references, trial periods, signalling, co-investment.
Set horizon & risk sharing – vesting, hold requirements, loss sharing; avoid “gamble for resurrection”.
Design guardrails – SLAs, covenants, decision rights, audit/observability.
Multitask protection – pair metrics (quantity × quality), include customer outcomes.
Review & recalibrate – watch for gaming and unintended consequences; iterate contract.
Map information gaps – what the agent knows/controls that you don’t.
Choose contract levers – pay mix β on results vs inputs, floors/caps, deferral, clawbacks.
Add screens & selection – references, trial periods, signalling, co-investment.
Set horizon & risk sharing – vesting, hold requirements, loss sharing; avoid “gamble for resurrection”.
Design guardrails – SLAs, covenants, decision rights, audit/observability.
Multitask protection – pair metrics (quantity × quality), include customer outcomes.
Review & recalibrate – watch for gaming and unintended consequences; iterate contract.
pitfalls and cautions
Paying the proxy – targets hit, mission missed (Goodhart).
Short-termism – annual bonuses that burn long-term value.
All-variable or all-fixed pay – misaligned risk sharing; mix matters.
One-metric comp – multitasking distortion; include quality/satisfaction/sustainability.
Over-monitoring – kills autonomy and intrinsic motivation; use trust + verification.
Adverse selection via rich terms – the wrong agents self-select into your scheme.
Short-termism – annual bonuses that burn long-term value.
All-variable or all-fixed pay – misaligned risk sharing; mix matters.
One-metric comp – multitasking distortion; include quality/satisfaction/sustainability.
Over-monitoring – kills autonomy and intrinsic motivation; use trust + verification.
Adverse selection via rich terms – the wrong agents self-select into your scheme.