To illustrate, consider the actions of Logan LaLandon, Vice Mayor of Shady Valley. The primary duty of the Vice Mayor is to act as Chairman of the Committee for the Historical Preservation of Footwear, which oversees the operations of the Shady Valley Shoe Museum. In the context of this present discussion, Logan LaLandon is the agent authorized to represent the citizens of Shady Valley when it comes to the Shady Valley Shoe Museum.

As Chairman of the Shoe Museum Committee, Logan, might be inclined to use a portion of the tax-funded budget to create a special, gated, parking space reserved just for him right next to the Shoe Museum front door. This parking space, while making his life easier on those rare occasions that he actually visits the museum (once in a blue moon), it does little or nothing for the museum other than wasting tax dollars and preventing other expenditures.

If he happens to authorize this parking space, and I'm not saying that he would (or did), then he would be abusing the authority given to him as Chairman of the Shoe Museum Committee (the agent) by the good people of Shady Valley (the principal).

Maximizing Utility

While the principals authorize the agents to do things that will maximize the utility of the principals, the agents are also people who seek to maximize their own utility. Given the choice between using Shady Valley tax dollars to improve the Shoe Museum (which benefits the principals, Shady Valley citizens) or reducing the distance he walks from parking space to museum front door (which benefits the agent, Logan LaLandon), the Vice Mayor triggers the principal-agent problem when he opts for the parking space.

Good for him, bad for Shady Valley. More utility for Logan, less utility for Shady Valley citizens.

Government Inefficiency

When political leaders fall victim to the principal-agent problem, an inefficient allocation of resources is bound to arise. Rather than making allocation decisions based on the amount of satisfaction generated for all of society (the principal), a political leader might allocate resources based on the satisfaction of only the political leader (the agent). As such, generating the greatest level of satisfaction from available resources, the criterion for efficiency, is difficult if not impossible.

Beyond Government

• Corporate Management: One noted example is the management of corporations. The principal in this case is the corporate stockholder and the agent is the manager or executive hired to run the corporation. The principal-agent problem arises as the manager seeks to maximize personal utility through unneeded company expenditures on travel (company jet), fringe benefits (country club membership), or working environment (rare imported teak wood office furniture) at the expense of corporate profits.


• Health Care Services: Another common example is provided by medical services. The principal in this case is the patient and the agent is the doctor who is paid to provide medical services. The principal-agent problem arises as the doctor seeks to maximize personal utility and a higher income through unneeded operations or diagnostic tests at the expense of the patients bank account.


• Higher Education Instruction: A third example is provided by higher education. The principal in this case is the student and the agent is the instructor paid to provide education. The principal-agent problem arises as the instructor structures the course and selects textbooks or other instructional materials to maximize personal utility by reducing work effort at the expense of the student's education.