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Principal Agent Problem : A situation that arises when an agent's incentives do not align with the interests of the principal that the agent is meant to represent.

Principal Agent Problem: A situation that arises when an agent's incentives do not align with the interests of the principal that the agent is meant to represent. This is from the video “Moral Hazard” in the Principles of Microeconomics course.

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These examples highlight a concept called the principal agent problem. Often when you hire someone, that person has more information than you do. Indeed, that's often why you pay to hire them. In the case of your car, you are the principal and the mechanic is your agent. Your incentive is to get your car fixed and not waste too much money. His incentive might be to get as much money out of you as possible. Given that he has information about cars that you don't, he can lie to charge more. In this case there are conflicting incentives, and you don't have the information to know a good deal from a bad deal.


Ideally, you would like to align the incentives of the mechanic with yours, so you don't get swindled. That is at least, in principle, how you can solve a principal-agent problem. No one likes to be ripped off, but the problem of moral hazard runs deeper than just the rip-off. The bigger problem is that the potential for a rip-off means that a transaction maybe less likely to occur in the first place. If you know the mechanic may recommend more service than is necessary, you might, for instance, pass on some recommended precautionary repairs and just wait until your car breaks down.


Of course, that can be inefficient. You’d prefer to perform that preventive maintenance and not break down unexpectedly. But because of asymmetric information, you can't trust your agent, the mechanic, and so you pass on those repairs for fear of being ripped-off.

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