The Principal-agent Problem

We have talked about incomplete contracts before and this problem is associated. Conflicts of interest and moral hazard issues arise when the city hires contractors to perform specific duties that involve low bid requirements and incomplete contracts because the best interests of the city and the contractor will not be aligned. The principal-agent problem develops when the city attempts to create a contract that has incentives to align the contractor's interests with those of the city. The city (the principal) attempts to create incentives for the contractor (agent)to act as the principal wants because the principal faces information asymmetry and risk with regards to whether the agent has effectively completed a contract.
The principal-agent problem can be associated as part of agency theory. It has similarities to game theory in that the "rules" are changed to favor specific actions favored by the principal.
An example of how the principal-agent problem occurs between the contractor (agent) and the city (the principal) is when they hire them to provide the highest quality street at the lowest cost. The contractor’s primary incentive is to provide the minimal amount of quality allowed by the contract to meet the low bid requirement; the incentive is structure to compensation the contractor for price not quality. The contractor is less likely to be concerned about quality because it fears losing business by being too costly.
If the city (the principal) hires a contractor (the agent) to construct a street without observation, all you can observe is how the street looks when you happen to view it. The contractor could have failed to properly construct the base, as required, or could have laid the pavement in one three (3) inch layer. By hiring an engineer to monitor the contractor's behavior, the city has a record of what the contractor actually did, although at some cost.
The contractor has information and expertise that the city does not have-indeed, that is why they are contractors. The city can observe the final street, but does not have the time to observe the contractor’s efforts. To complicate matters further, even when the contractor’s behavior can be observed, the city does not generally have the expertise to evaluate it. Everyone can see the final product (street), but it takes very detailed knowledge to understand how high the quality could have been if the contractor had acted differently.
The engineer hired to do the observation is also a contractor. They are hired because they have information and expertise that the city does not have-indeed, that is why they are engineers. The city cannot ensure that the engineer’s interests are perfectly aligned with the city’s interests. To complicate matters further, the city does not generally have the expertise to evaluate the engineer’s performance. Everyone can see the final product (street), but it takes very detailed knowledge to understand how high the quality could have been if the engineer’s interests were perfectly aligned with the city.
City hires staff and lawyers with some of the relevant expertise to monitor contracts, but again this is costly.
These examples illustrate the principal-agent problem. This is the problem of designing mechanisms that will induce agents to act in their principals' interests. In general, unless there is costly monitoring of agents' behavior, the problem cannot be completely solved. Hired staff, lawyers, engineers and contractors will generally wish to pursue their own goals. They cannot ignore the city’s interests, however, because if they perform badly enough they will lose their jobs. Just how much latitude they have to pursue their own goals at the expense of the city’s interests depends on many things, including the degree of competition, risk, contracts and moral hazard.