The Principal-Agent Problem 🤔
The principal-agent problem happens when one person or group (the "principal") hires another person or group (the "agent") to act on their behalf, but their goals don't perfectly align. The issue? The agent has more information and might exploit this for their benefit. Now, imagine this in a student-tutor-parent triangle you might be familiar with.
The Characters
The Parents (Principal):
The ones paying for the lessons. They want their kid to learn economics but also want to save money. Unfortunately, they’re too busy to track every dollar spent.
The Student (Agent):
This kid’s supposed to represent the family’s best interests. But, uh… they’re 15. So their idea of financial responsibility is, “Hey, if Mom and Dad aren’t watching, I’ll just book, like, 20 economics lessons. I mean, what’s money anyway? A social construct?”
The Tutor (World's Best Economics Tutor):
A skilled economics teacher who sees dollar signs 💵 every time the word "lesson" is mentioned (I admit it). They’re thinking, "This kid is great! Let’s turn them into an economic prodigy... one premium lesson at a time." As a person who teaches the importance of profit-maximization, the tutor definitely isn't going to say no if you book extra lessons.
A Familiar Problem 🤷♀️
The parents (principal) entrust the student (agent) with the decision to book lessons. The student, knowing their parents aren’t monitoring the budget closely, books way more lessons than necessary. The tutor, eager to maximize profits, happily obliges and even encourages more lessons. "We could stop at supply and demand, but why not dive into game theory? And fiscal policy? And behavioral economics? You’re doing great, champ!" 👏
The student’s reasoning?
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“It’s not my money.” 💸
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"I need to get into university." 🎓
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“I get to learn more!” 🤓
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“And, hey, the tutor says I’m a genius. Who wouldn’t want more lessons?!”
The parents, meanwhile, have no clue that their credit card is being swiped faster than mine is on a weekend trip to Macau. 🎰 In economics we might call this overconsumption, or in other words - a good time!
An Analysis
Here are three key insights of the principal agent problem:
*Incentive Misalignment:
- The parents want to save money while ensuring their child learns enough.
- The student wants to learn more but has no incentive to minimize costs.
- The tutor wants to teach... but mostly wants to make money.
- These incentives are not entirely aligned, so which one takes precedent?
*Information Asymmetry:
- The parents don’t know how many lessons are actually needed.
- There is no immediate feedback mechanism to parents.
- The student and tutor know this and might overbook lessons because... why not?
- One party (or two if you count the tutor) knows more than the other party.
- The party with leverage (the agent's) will make the decision.
*Moral Hazard:
- The student acts recklessly with the parents’ money because they’re not bearing the cost.
- The tutor has no moral obligation to stop the student from overbooking. After all, more lessons = more money.
- Remember moral hazard can be defined as the loss of incentive to take care due to a third party's generosity. Moral hazard = generosity damage. 💔
The parents eventually check their credit card statement. “HOW MUCH are these lessons? What are you learning? How to run the Federal Reserve?”
"Yes."
Fortunately, the tutor was able to provide the parents with a compelling justification for their investment. The tutor explained that top American universities often charge over $20,000 per semester, and successfully completing AP Microeconomics or AP Macroeconomics can replace two full university-level courses. This translates to a potential savings of $8,000! ($20,000 ÷ 5 courses × 2 courses). Considering this, the tutor's retainer at Hong Kong Econ Tutor —priced at only $1,000 for 10 lessons—was positioned as an exceptionally reasonable investment. Further, the tutor highlighted the long-term benefits of this education, emphasizing how mastering economics could contribute to the student’s success at top universities and, ultimately, their ability to generate greater wealth in the future. With this perspective, the parents recognized the value of the program and felt completely reassured about their very wise decision to invest in their child's future. 😎