The principal–agent problem
Bibhas Chandra Saha · 2024
When an employer is uninformed about a worker&s;s productivity whom he is about to hire, there is risk of adverse selection. A somewhat similar problem arises when the employer knows his worker&s;s productivity but cannot observe her work or effort. In this case, there is a risk of moral hazard. In the framework of two individuals engaging in a potentially beneficial transaction, we study the problems of adverse selection and moral hazard. Assuming that the un-informed party has the power to write a take-it-or-leave-it offer, we study how the optimal contracts can be designed to elicit correct information or to induce best effort. Generally, the contract needs to be distorted from the first-best level to avoid adverse selection by causing inefficiency and yielding information rent. To mitigate moral hazard, an incentive has to be given to induce correct effort, which, in turn, requires not providing complete insurance.