Jonathan Cutrell

Principal-Agent Problem

Formal definition:

Also known as the “agency dilemma.” An agency is motivated to act in their own interests, which is often competing with or in direct contradiction to the interests of the principal.

How it applies

This is one of the most important models to understand, because it has broad-sweeping effects. We’ll list a handful of examples here.

  • Realtor and home-seller - The realtor’s upside is much smaller than the home seller’s. Leaving a house on the market for an extra few weeks is less attractive than taking a sub-optimal deal, as the guarantee of the majority of the upside is often a stronger incentive than the small delta for the optimal deal.
  • Contractor and Consumer - Especially if the contractor’s work is based on hourly rates, the contractor is incentivized to spend a longer amount of time on a project than is necessary to complete the work. The customer is incentivized to shorten the project as much as possible. This often leads the contractor to provide insurance by a guaranteeing a ceiling. (Note: Assuming the ceiling isn’t based on an artifically high estimate, this extra risk for the agent can be compensated for by charging a higher hourly rate.)
  • Pharmacies and Patients - At a macro-level, the pharmacy industry is incentivized to promote the effectiveness of a given drug, and simultaneously not eliminate the need for their drug (by entirely curing the given disease). (Note: with this said, pharmaceuticals have drastically improved life expectancy and quality of life for the majority of people who have access to them.)

Written by Jonathan Cutrell, Director of Engineering at PBS and podcast host at Developer Tea. You can follow him on Twitter at @jcutrell.