The Principal Agent Problem (Cambridge International A-Level Economics)
Exam board Cambridge International · A-LevelUpdated 2026-03-16
Ownership and control
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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
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Because managers control daily decisions, they may prioritise higher salaries, bonuses, prestige, or firm expansion instead of shareholder profits
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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
| Example | Explanation |
|---|---|
| Public limited companies | - A board of directors or executives are responsible for decision-making in public traded companies - A shareholder owns part of business but usually lacks influence over business decisions - Conflicts of interest may arise if shareholders prioritise profit maximisation while the board of directors prioritise other goals, such as maximising sales growth |
| Family businesses | - Not all family members are involved in daily management - Control rests with a small group of family members or non-family executives who manage operations - Conflicts of interest may arise if some family members aim to pursue objectives such as long-term stability and family values while other members aim to pursue profit maximisation |
- 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
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