── ── Mental model
Principal–Agent Problem
One party (the principal) delegates to another (the agent) whose interests differ and whose actions can't be fully observed — producing agency cost: monitoring spend + agent bonding spend + residual loss. Formalized by Jensen & Meckling (1976). Structure produces the behavior, not character — so the fix is structural.
How it works
Step 1 — Identify structure Principal / Agent / What principal wants / What agent would do absent intervention / What principal cannot observe.
Step 2 — Diagnose misalignment 1-3 dominant types: effort · risk · time horizon · info asymmetry · adverse selection · moral hazard · multitasking · hidden self-dealing.
Step 3 — Estimate agency cost Monitoring cost + bonding cost + residual loss = total. Order-of-magnitude is enough.
When to use it
- someone asks why an employee, executive, contractor, board member, or fund manager isn't acting in the org's interest
- a compensation or incentive structure is being designed
- outsourcing or partnership terms are being negotiated
- someone says 'agency cost,' 'moral hazard,' 'skin in the game,' or 'incentive misalignment
When not to use it
When the decision is routine and reversible, applying a formal method costs more than it returns.
Worked example
Jensen-Meckling 1976 and the Enron Collapse, 2001
The principal-agent framework's foundational paper was Jensen and Meckling's 1976 article. Their central argument was that the modern public corporation — with diffuse shareholders (principals) and concentrated management (agents) — has structural agency costs that cannot be eliminated by managerial good intentions, only mitigated through ownership structure, debt structure, and contractual design.
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