A bit on the Principal Agent Problem

Recently, Sambaran Mitra asked:

Why would an honest person run for public office or serve as a committee member of a resident welfare association? What kind of system will provide the right incentives for honest people to assume public office?

Designing proper mechanisms for ensuring honest behavior in officials is well-understood. The general class of problems is known as the “principal agent” problems. 

The politicians are the agents of the citizens who are the principals; the resident welfare association members are the agents of the residents who are the principals. The managers of a firm are the agents and the shareholders of the firm are the principals. The workers are the agents and the owner of the firm is the principal.

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