The Principal Agent Problem (Cambridge (CIE) A Level Economics): Revision Note

Ownership and control

• The principal–agent problem occurs when a manager (agent) makes decisions on behalf of an owner (principal) but may pursue their own interests rather than maximising the principal’s objectives, usually profit

  • Principals: owners or shareholders of a firm

  • Agents: managers hired to run the firm

• Because managers control daily decisions, they may prioritise higher salaries, bonuses, prestige, or firm expansion instead of shareholder profits

• The problem arises due to separation of ownership and control and asymmetric information, where shareholders cannot perfectly monitor managers.

Examples of the principal-agent problem

• Ultimately, the principal–agent problem is a form of market failure caused by information gaps. It can result in poor resource allocation, such as investing in unnecessary projects or hiring staff for prestige rather than productivity