Example: Real Estate Agents and Home Sellers

The principal-agent problem (or agency dilemma) arises when one person (the "agent") is allowed to make decisions on behalf of another person (the "principal"), but their interests may not necessarily align.

Scenario: Imagine you want to sell your house, and you hire a real estate agent to represent you in the sale.

Principal: You, the homeowner.

Agent: Real estate agent.

Interests:

• Your interest (as the principal) is to sell your house for the highest price possible.
• The real estate agent's interest (as the agent) might be to sell the house as quickly as possible.

Problem: Suppose your house could be sold for $300,000 if you wait for a couple of months, or $280,000 if sold within a week. Selling for the higher price would net you an additional $20,000 (less a small increase in the agent's commission).

However, from the agent's perspective, waiting might only increase their commission by a small amount, say $500 (if we assume a 2.5% commission rate). They might prefer to make a quick sale, get the commission earlier, and move on to other clients. Hence, the agent might not be as motivated to wait for a higher offer, whereas you, as the homeowner, might prefer to wait for the potential of an extra $20,000.

Solution: To mitigate the principal-agent problem, contracts can be designed to better align the interests of the principal and agent. For instance, a homeowner could offer a bonus to the agent if the house sells above a certain price threshold, or the commission structure could be progressive based on the sale price.