The problem of how person A can motivate person B to act for A’s benefit while still following self-interest. The principal, A, may be an employer and the agent, B, an employee, or the principal may be a shareholder and the agent a director of a company. The problem is how to devise incentives which lead agents to report truthfully to the principal on the facts they face and the actions they take, and to act for the principal’s benefit. Incentives include rewards such as bonuses or promotion for success, and penalties such as demotion or dismissal for failure to act in the principal’s interests. See also contract theory; mechanism design.
Reference: Oxford Press Dictonary of Economics, 5th edt.
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