A principal-agent relationship exists when one individual or group, the principal, depends on another individual or group, the agent, to take actions that influence the principal's welfare. For example, in a corporate environment, there is a misalignment of interest between shareholders and managers. Shareholders own the company and aim to maximize their wealth. Managers make operational and strategic decisions. They may focus on personal career growth, job security, or expanding the company's size and influence, even if it doesn't maximize shareholder value, which may not always align with shareholders' goals. The ideal scenario involves alignment between the two parties' objectives. However, their interests may diverge.

For instance, consider a company that produces kitchen appliances such as blenders and toasters. A manager within the company, driven by personal enthusiasm for sustainability, proposes expanding into solar-powered home devices. While the idea is innovative, the company lacks the technical expertise, supply chain networks, and market experience to succeed in this new venture. The manager, however, supports the idea as it aligns with their personal values and might elevate their reputation in environmental advocacy circles. From the shareholders' perspective, such a shift could be a misuse of company resources, diverting focus from profitable core operations.

This example shows how agents may act in their own interest. Their actions can conflict with the goals of principals, causing inefficiencies and potential losses.