The Principal-Agent Problem

I hired a plumber to fix a slow-draining bathtub recently. It was a fantastic experience. I plan to be a customer of that particular plumber for a long time.

Here’s why: The guy took a good look at my problem, asked a few questions, and then proceeded to explain what was going on to me in terms I could understand. He showed me why my efforts at snaking were fruitless, told me what he could do about it, and recommended I point out a particular quirk about the situation to future plumbers, if the problem came up again.

Usually when I have to hire somebody to do work like this, work I don’t understand, I find it stressful. And it’s not an infrequent scenario: It happens when I hire someone to fix my car, file my taxes, treat my lawn, manage my investments, treat my illness, and on and on.

When you shop for a service to do work and you’re not able to assess the quality of that work, trust has to come into play. You have to trust their expertise and then you have to trust that they’re not screwing you over on price and/or quality.

This is known as the “Principal-Agent Problem”. In all these cases, I’m the principal, and I’m hiring an agent to do some work on my behalf. The problem comes when their incentives don’t align with mine.

For instance, as soon as I pay my plumber by the hour, he has a small, direct, financial incentive to take more time to do his work. And I have no way of judging whether he could’ve done the job in four hours instead of five. I have to trust him.

This plumber could’ve recommended we tear out these very old pipes and replace them. I would at the very least have given a lot of weight to his suggestion, because I don’t know squat about plumbing.

I’d probably have gotten a second opinion, though. That’s a way to mitigate some risk when putting your trust in an agent. Just the existence of that option means your agent’s incentives are more nuanced than trying to milk you for as much money as possible. An agent needs your trust and will generally act accordingly. One who doesn’t won’t be in business for long.

I think about the principal-agent problem a lot. Not just when I’m hiring agents: As a developer, I’m often the agent myself. I need to build trust and to align my incentives with those of my clients.

It helps to focus on long-term incentives, not just short-term financial ones.