Also sometimes referred to as the principal-agent problem . The difficult but extremely important and recurrent organizational design problem of how organizations can structure incentives so that people ("agents") who are placed in control over resources that are not their own with a contractual obligation to use these resources in the interests of some other person or group of people actually will perform this obligation as promised -- instead of using their delegated authority over other people's resources to feather their own nests at the expense of those whose interests they are supposed to be serving (their "principals"). Enforcing such contracts will involve transaction costs (often referred to as agency costs), and these costs may sometimes be very high indeed.
Directors, managers and employees of business corporations are supposed to use their delegated authority to maximize the total financial returns from the business to its owners, the shareholders. Physicians, nurses, clinical psychologists, teachers, lawyers, CPAs, financial advisors and other service-oriented professionals are supposed to use their specialized knowledge and skills solely in the best interests of the patients, students or clients who have placed themselves (and some of their resources) in professional hands in exchange for the professionals' promises to act on their behalf. Government officials, judges and politicians in countries embracing the concept of popular sovereignty are instructed to use the power granted them to make public policy decisions that further some reasonable concept of "the public interest" (usually conceived as the common interests of their constituents or of the country's citizenry at large). Trustees, managers, and employees of non-profit charitable institutions are supposed to use their control over their organization and its resources to promote the general purposes for which the institution was chartered and endowed. Yet if agents are really to perform consistently in the manner they are supposed to do (that is, in the interests of other people), they will need to be suitably motivated by some combination of material incentives , moral incentives , and/or coercive incentives that will make it seem worth their while to attend faithfully to their service obligations and fiduciary duties. The more autonomy that agents have to have in order to do their particular kind of work effectively and efficiently, the less useful coercive sanctions are likely to be, and the more important it becomes for agents' moral and material incentives to be appropriately aligned with their broader obligations to their principals. That is, organizations need to be structured in such a way so the agent will expect that diligently serving the interests of his or her principals will also be in his or her own long-run best interests. In order to accomplish this, the principals need to be reasonably clever in setting up the initial rules of the game that are set in the employment contract , sufficiently vigilant in keeping track of their agents' quality of performance over time, and willing to bear at least some minimum level of "agency costs" in order to provide the necessary incentives . More...