Software Development Outsourcing and The Principal-Agent Problem (Part I)

What is a Principal-Agent Problem?

It’s a theory that describes the pitfalls that often arise when one entity (agent) is working on behalf of another (principal). It is common in most parts of life and can be a real danger to those unaware of its main implications.

Example of a Principal-Agent Problem

In this theory, the Principal is the entity that owns the product/asset and hires the Agent to act on their behalf (performing tasks). Therefore, most business interactions between two or more parties can be seen in the light of this theory. Let’s consider a very simplified example:

1. Your kitchen sink is not working properly, so you call a plumber.

2. The plumber analyzes the problem and tells you he needs to replace some parts, for a cost of $X for parts + $Y/hour of labor.

3. At this point, we already have two main problems:

– You are not knowledgeable in plumbing, so you can’t evaluate his expertise and diagnosis.

– His goal (maximizing profit, having as much hassle as possible) is contrary to yours (paying the least possible, while having the longer lasting solution in place).


4. Moving on, during the fixing process, more problems might arise or he might find ways to further increase his revenue, by taking more time than needed or suggesting pricier parts. He might go as far as using parts specific to a manufacturer, which would make it harder for you to use other plumbers in the future.

In a principal-agent relationship, both parties act rationally based on institutions like private property and freedom of contract. The agent’s actions impact the principal’s success and profit, but the agent has discretionary freedom due to incomplete and asymmetric information. This creates “Ex- Aante” uncertainty and “Eex- Ppost” disadvantages for the principal. The agent may act opportunistically to maximize personal profit, causing a divergence of interests and potentially leading to hidden characteristics, intentions, and actions.

What causes the Principal-Agent problem?

In a Principal-Agent relationship, both parties act rationally based on their self-interests and freedom of contract. Their divergence of interests can potentially lead to hidden information, intentions and actions, which might harm the success and profitability of their respective operations. Asymmetric information and high monitoring costs are the main drivers of uncertainty.

Be sure to read Part II of this article, where we will demonstrate how the principal-agent theory can be applied specifically to the context of Software Development Outsourcing.