Also sometimes referred to as the principal-agent problem. The difficult but extremely important and recurrent organizational design problem of how organizations can structure incentives so that people ("agents") who are placed in control over resources that are not their own with a contractual obligation to use these resources in the interests of some other person or group of people actually will perform this obligation as promised -- instead of using their delegated authority over other people's resources to feather their own nests at the expense of those whose interests they are supposed to be serving (their "principals"). Enforcing such contracts will involve transaction costs (often referred to as agency costs), and these costs may sometimes be very high indeed.

Directors, managers and employees of business corporations are supposed to use their delegated authority to maximize the total financial returns from the business to its owners, the shareholders. Physicians, nurses, clinical psychologists, teachers, lawyers, CPAs, financial advisors and other service-oriented professionals are supposed to use their specialized knowledge and skills solely in the best interests of the patients, students or clients who have placed themselves (and some of their resources) in professional hands in exchange for the professionals' promises to act on their behalf. Government officials, judges and politicians in countries embracing the concept of popular sovereignty are instructed to use the power granted them to make public policy decisions that further some reasonable concept of "the public interest" (usually conceived as the common interests of their constituents or of the country's citizenry at large). Trustees, managers, and employees of non-profit charitable institutions are supposed to use their control over their organization and its resources to promote the general purposes for which the institution was chartered and endowed. Yet if agents are really to perform consistently in the manner they are supposed to do (that is, in the interests of other people), they will need to be suitably motivated by some combination of material incentives, moral incentives, and/or coercive incentives that will make it seem worth their while to attend faithfully to their service obligations and fiduciary duties. The more autonomy that agents have to have in order to do their particular kind of work effectively and efficiently, the less useful coercive sanctions are likely to be, and the more important it becomes for agents' moral and material incentives to be appropriately aligned with their broader obligations to their principals. That is, organizations need to be structured in such a way so the agent will expect that diligently serving the interests of his or her principals will also be in his or her own long-run best interests. In order to accomplish this, the principals need to be reasonably clever in setting up the initial rules of the game that are set in the employment contract, sufficiently vigilant in keeping track of their agents' quality of performance over time, and willing to bear at least some minimum level of "agency costs" in order to provide the necessary incentives.

Examples of some techniques commonly used to overcome or alleviate the agency problem would include: (1) profit-sharing bonuses, contingency fees, sales commissions, merit raises, executive stock options and various other contractually specified methods of setting the amount of the agent's financial compensation in proportion to measurable results; (2) organizational hiring and promotion policies for people in responsible positions (agents) that emphasize identifying and selecting candidates whose reputation (based ideally on past performance) indicate they are "well-motivated,""dedicated to the ethics of the profession," and generally "of good character" -- i.e., people who feel a strong sense of moral obligation to do their best to do what they have promised to do, even when no one is likely to be watching; (3) institutional arrangements of accountability (such as boards of directors, auditing committees, inspector generals' offices, professional society ethics committees, and government regulatory boards) for detecting and then punishing extreme dereliction of duty, either by simply firing and disgracing (or perhaps de-licensing) the unworthy agent or possibly by aggressively pursuing civil or criminal penalties through the courts; (4) arrangements such as elections whereby the recent performance of the agent may be periodically scrutinized by his or her principals and competing candidates for the job may be allowed to make their case for replacing the incumbent agent by revealing his or her shortcomings and showing how performance might be improved through a change in command.

The bottom line, however, is that the agency problem can never be 100% solved in a world where virtually everyone has a healthy regard for their own self-interest and the relevant information for evaluating performance is imperfect, costly to obtain and unequally distributed between the agent and his principals. Indeed, rational principals will only pursue the available techniques for control to the point that the marginal increment in "agency costs" rise to equal the marginal benefits to them of the additional increment in "faithfulness" that they produce. (That is to say, sometimes it is cheaper for principals to endure a certain amount of dereliction of duty by their agents than it is to pay for the precautions needed to prevent or punish it.) In some kinds of institutions -- especially those where results are not readily measurable with much precision, those where the nature of the agents' work is such as to require a very high degree of expert judgment, those where lines of responsibility and authority are very complex, those where agents work individually in widely dispersed work places, those where the agent's activities necessarily involve a lot of "judgment calls" to cope with rapidly changing circumstances and highly uncertain information, and those where large numbers of principals have only relatively small individual "stakes" at risk -- the incentives for agents faithfully to represent their principals may easily become so weak as to be largely ineffective. Experience demonstrates that these kinds of organizations often come to be run mainly for the benefit of the agents (managers and other employees, service professionals, politicians, officials) rather than their purported principals (stockholders, voters, taxpayers, clients, etc.). Two of the important tasks of the academic disciplines of business administration and public administration are to identify, and then to devise cheaper substitutes or remedies for, organizational arrangements that are characterized by costly agency problems.

[See also: incentive, marginal analysis, bureaucracy, bureaucratic politics]