Explain, giving a relevant example, what is meant by a principal-agent problem.

The principal-agent problem occurs when there is a conflict of interests and priorities between the principal and the agent. The agent can act in a manner contrary to the expectations of the principal. An example of this relationship is the CEO of a company and the shareholders. The CEO might decide to plow back the companies profits to expand the business contrary to the shareholders' expectations to receive dividends. The solutions to this problem involve the principal clarifying their expectations and monitoring the results. This can be done by:

• Providing incentives- the principal can create incentives for the agents to act in an expected manner and reduce shirking, such as profit-sharing plans.
• Contract clauses- principals have come up with employment contracts where the compensation of the agent is mainly dependent on the performance level.
• Frequent audits- this enables the early detection and mitigation of risks.