A principal-agent problem occurs when an agent of an organization responds to personal incentives and acts in their own best interests, even when those don't align with the organization's owners (principals).

Common examples of this relationship include corporate management (agent) and shareholders (principal), elected officials (agent) and citizens (principal), or brokers (agent) and buyers/sellers (principals).

They happen when there is a conflict in priorities between an agent (someone employed to do a task on behalf of an owner) and a principal (owner). This arises from the agent having different incentives than the principal.

A common example of this is when a salesperson makes a commission off of the amount of sales made where the owner only earns money from profit made. So a salesperson may pursue sales that aren't profitable to maximize their own benefit, even if this is not in the best interest of the principal that they represent.

Another common situation is when an agent pursues something on behalf of an organization that makes them personally look good or gain favor with someone, even if this doesn't align with the goals of the principal that they represent. For example, a politician giving special subsidies or protections to an industry in order to gain their support.

A real estate agent may wish to list your home for a lower price so that it will be less work to sell because they get 3% of the price, whereas you only get what's left over after everything is paid off. A lawyer may encourage you to litigate excessively because they get paid by the hour whereas you are the one footing the bill. An insurance agent may recommend a larger policy than you need.

Whenever you have an agent (such as a lawyer representing you, a real estate agent selling your house, or an employee), ask yourself: What are their incentives? Where do they differ from mine? When you see this, make sure you align incentives where you can, and push for what's in your best interest where there is a gap.

When you are working with an agent of a different organization, ask yourself: What are this person's incentives? How can I find a solution where I get what I want in a way that satisfies this individual's priorities? Looking for solutions along these lines can lead to great results.

Charlie Munger said, "Show me the incentives, and I'll show you the outcome." Keep the principal-agent problem in your thoughts when you are working with people, and you increase your chances of a successful outcome.

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