what causes the principal agent problem 
logically the principal cannot constantly monitor the agent s actions the risk that the agent will shirk a responsibility make a poor decision or otherwise act in a way that is contrary to the principal s best interest can be defined as agency costs additional agency costs can be incurred while dealing with problems that arise from an agent s actions agency costs are viewed as a part of transaction costs agency costs may also include the expenses of setting up financial or other incentives to encourage the agent to act in a particular way principals are willing to bear these additional costs as long as the expected increase in the return on the investment from hiring the agent is greater than the cost of hiring the agent including the agency costs solutions to the principal agent problemthere are ways to resolve the principal agent problem the onus is on the principal to create incentives for the agent to act as the principal wants consider the first example the relationship between shareholders and a ceo the shareholders can take action before and after hiring a manager to overcome some risks first they can write the manager s contract in a way that aligns the incentives of the manager with the incentives of the shareholders the principals can require the agent to regularly report results to them they can hire outside monitors or auditors to track information in the worst case they can replace the manager designing a contract involves linking the interests of the principal and agent by tackling issues such as misaligned information setting methods to monitor the agents and incentivizing the agent to act in the best way possible for the principal compensation is always a motivating factor and a high priority for an agent linking compensation to certain criteria such as a performance evaluation can ensure that the agent performs at a high level if their compensation depends on it this is almost a surefire way to align the interests of both the principal and the agent methods of agent compensation include stock options deferred compensation plans and profit sharing in these methods if the agent performs well they will see a direct benefit if they do not they will be hurt financially at its root it s the same principle as tipping for good service theoretically tipping aligns the interests of the customer the principal and the agent the waiter their priorities are now aligned and are focused on good service examples of the principal agent problemthe principal agent problem can crop up in many day to day situations beyond the financial world in all of these cases the principal has little choice in the matter an agent is necessary to get the job done 