Agency Theory

We consider the simplest possible organization: one boss (or “Principal”) and one worker (or “Agent”). One of the earliest applications of this Principal-Agent model was to sharecropping, where the landowner was the Principal and the tenant farmer was the Agent, but in this course we will typically talk about more familiar organization structures. For example, we might consider a firm’s shareholders to be the Principal and the CEO to be the Agent. One can also enrich the model to analyze a chain of command (i.e., a Principal, a Supervisor, and an Agent), or one Principal and many Agents, or other steps towards a full-fledged organization tree.

The central idea behind the Principal-Agent model is that the Principal is too busy to do a given job and so hires the Agent, but being too busy also means that the Principal cannot monitor the Agent perfectly. There are a number of ways that the Principal might then try to motivate the Agent. Taken literally and alone, the basic Principal-Agent model may seem too abstract to be useful. But we begin with this model because it is an essential building block for many discussions throughout the course—concerning not only managing the incentives of individuals but also managing the incentives of organizational units (such as teams or divisions) and of firms themselves (such as suppliers or partners).