When it comes to sharing the same goal for your business, it is hard enough to make others feel what you feel about achieving the goals. Also, it is quite impossible to make them work if they are not receiving the reward or the punishment based on the outcomes that they deliver through their decisions.

This old problem among the organization is known as the principal-agent problem that a business owner must know to improve the outcomes from the employees.

What is the definition of a principal-agent problem?

The principal-agent problem tends to arise when an agent agrees to act or work in favor of another principal in return for incentives. Such an agreement can come up with a huge amount of cost for the agent. Hence it leads to problems like a conflict of interest or moral hazards. Due to the incurred costs, the agent might tend to pursue his/her agenda and ignore the interest of the principal. Thus, it causes the occurrence of principal-agent problems.

The principal here faces the risk of failure and skewed information symmetry, which raises the cost of the agent and results in subsequent conflict in the interest.

In other words, the principal-agent problem refers to the inherently competing priorities between an employee and an owner. Here the employee rarely acts as per the best interest of the owner. Rather they act for their own best interest.

When a principal hires an agent, they give away some degree of control over their asset. With this given control, either the principal will get benefit from an agent, or it will make them suffer from poor performance. When the agent takes contour over the project or the asset, they become the ultimate owner who owns all the outcomes. For example, Bernie Madoff's scam is one of the most notable instances of Ponzi schemes. He created a sham business which did cost the investors at least $16.5 billion.

Thus, if you are a principal, then you need to know how to delegate properly. It is highly important to understand the power of incentives which play a very significant role in the principal-agent problem.

Using incentives to solve this problem:

The best way to deal with your principal-agent problem can be using the right incentives for your agent. The incentives that you are crafting need to get aligned with the incentive of the principal.

Incentives can work as both a reward or a punishment which can have an impact upon human behavior. In business organizations, the incentives can be anything ranging from money, company, status, equity to the expense account, etc.

Incentives have the great power to explain human behavior. The right kind of incentive can have a great influence on the behavior of the agent. One of the most relevant problems is, people are more focused on whether money or status is what they do.

Thus, the principal needs to find a way to incentivize the agent to acquire the best of interest for the business.

Conclusion

While the principal-agent problem is one of the very old problems that business organizations suffer from, it can be solved through the proper use of incentives. However, the principal needs to be very strategic with the steps.

"All the alleged key causes of SOE [State-Owned Enterprise] inefficiency, the principal-agent problem, the free-rider problem, and the soft budget constraint are, while real, not unique to state-owned enterprises. Large private-sector firms with dispersed ownership also suffer from the principal-agent problem and the free-rider problem. So, in these two areas, forms of ownership do matter, but the critical divide is not between state and private ownership it is between concentrated and dispersed ownerships." Ha-Joon Chang.