Principal Agent Model In political science and economics, the principalagent problem or agency dilemma concerns the difficulties

in motivating one party (the "agent"), to act on behalf of another (the "principal"). Common examples of this relationship include corporate management (agent) and shareholders (principal), or politicians (agent) and voters (principal)[1]. The two parties have different interests and asymmetric information (the agent having more information), such that the principal cannot directly ensure that the agents are always acting in its (the principals') best interests,[2] particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe. Moral hazard and conflict of interest may arise. The deviation from the principal's interest by the agent is called 'agency costs.'[2] 1. Employment Contract In the context of the employment contract, individual contracts form a major method of restructuring incentives, by connecting as closely as is optimal the information available about employee performance, and the compensation for that performance. Because of differences in the quantity and quality of information available about the performance of individual employees, the ability of employees to bear risk, and the ability of employees to manipulate evaluation methods, the structural details of individual contracts vary widely, including such mechanisms as piece rates, [share] options, discretionary bonuses, promotions, profit sharing, efficiency wages, deferred compensation, and so on. 1. Non-financial compensation Part of this variation in incentive structures and supervisory mechanisms may be attributable to variation in the level of intrinsic psychological satisfaction to be had from different types of work. Sociologists and psychologists frequently argue that individuals take a certain degree of pride in their work, and that introducing performance-related pay can destroy this psycho-social compensation, because the exchange relation between employer and employee becomes much more narrowly economic, destroying most or all of the potential for social exchange. 2. Team production Australian survey data to show that when agents are placed on individual pay-for-performance schemes, they are less likely to help their coworkers. This negative effect is particularly important in those jobs that involve strong elements of team production (Alchian and Demsetz 1972), where output reflects the contribution of many individuals, and individual contributions cannot be easily identified, and compensation is therefore based largely on the output of the team. In other words, pay-for-performance increases the incentives to free-ride, as there are large positive externalities to the efforts of an individual team member, and low returns to the individual (Holmstrom 1982, McLaughlin 1994). 1. Performance evaluation The major problem in measuring employee performance in cases where it is difficult to draw a straightforward connection between performance and profitability is the setting of a standard by which to judge the performance. One method of setting an absolute objective performance

standardrarely used because it is costly and only appropriate for simple repetitive tasksis timeand-motion studies, which study in detail how fast it is possible to do a certain task. The reason that employees are often paid according to hours of work rather than by direct measurement of results is that it is often more efficient to use indirect systems of controlling the quantity and quality of effort, due to a variety of informational and other issues (e.g., turnover costs, which determine the optimal minimum length of relationship between firm and employee).