The principal-agent problem refers to conflicts of interest and moral hazard issues that crop up when a principal employs an agent to carry out certain specific duties which may be in the best interests of the principal but may be expensive, or may not be in the best interests of the agent. This problem occurs when a principal creates an atmosphere in which an agent has incentives to align its interests with those of the principal. Principals make incentives to ensure the agent act as per their requirements because they face information asymmetry and risk concerning whether the agent has successfully finished a contract or not.
Employment contracts serve as a key method of streamlining incentives by connecting the best possible information available about employee performance with the compensation for that performance. The details of these contracts may differ due to the variations in the quantity and quality of information on hand regarding the performance of individual employees, their risk-bearing ability and their capacity to maneuver assessment methods. The features of the contract may vary according to the employment type. For example, workers in a production unit may be paid hourly wages whereas salesmen may mostly be paid in the form of a commission.
There are essentially four principles applicable to contract design. The Informativeness principle implies that any parameter of performance that shows the effort level chosen by the agent must be incorporated in the employment contract. The Incentive-Intensity principle states that there are four factors that decide the optimal intensity of incentives; extra profits created by the agents efforts, the accuracy with which the required activities are evaluated, the ability of the agent to bear risk and the agents receptiveness to incentives. The Monitoring Intensity principle implies that scenarios in which the optimal intensity of incentives is high corresponds greatly to situations in which the optimal level of monitoring is also high. The fourth principle or the Equal Compensation principle states that behaviors valued by the employer should be equally valuable to the employee.
Performance evaluation can be of two types objective evaluation and subjective evaluation. An objective evaluation can be carried by studying in detail how quickly a task can be done. It also takes into consideration the performance of an employee in comparison with peers. Subjective performance evaluation, on the other hand, provides a more reliable and fair assessment of an employees performance.
The effects of incentives of a pay-for-performance structure are dealt with using tournaments. In a tournament model, Workers are motivated to supply effort by the wage increase they would earn if they win a promotion. Deferred compensation is another incentive structure which is essentially an agreement between worker and firm to commit to each other.
Providing a solution to the principal-agent problem at an early stage can be helpful for firms in managing employees effectively.