Chapter 3 The principal-agent problem The principal-agent problem describes a class of interactions between two parties to a contract, an agent and a principal. The legal origin of these terms suggests that the principal engages the agent to act on his(the principal s behalf. In economic applications, the agent is not necessarily an employe of the principal. In fact, which of two individuals is regarded as the agent and which as the principal depends on the nature of the incentive problem Typically, the agent is the one who is in a position to gain some advantage by reneging on the agreement. The principal then has to provide the agent with incentives to abide by the terms of the contract We divide principal-agent problems into two classes: problems of hidden action and problems of hidden information. In hidden-action problems, the agent takes an action on behalf of the principal. The principal cannot observe the action directly, however, so he has to provide incentives for the agent to choose the action that is best for the principal. In hidden-information prob ems, the agent has some private information that is needed for some decision to be made by principal. Again, since the principal cannot observe the agent's information, he has to provide incentives for the agent to reveal the infor mation truthfully. We begin by looking at the hidden-action problem, also known as a moral hazard problem. 3.1 The model For concreteness, imagine that the principal and the agent undertake a risky venture together and agree to share the revenue. The agent takes someChapter 3 The principal-agent problem The principal-agent problem describes a class of interactions between two parties to a contract, an agent and a principal. The legal origin of these terms suggests that the principal engages the agent to act on his (the principal’s) behalf. In economic applications, the agent is not necessarily an employe of the principal. In fact, which of two individuals is regarded as the agent and which as the principal depends on the nature of the incentive problem. Typically, the agent is the one who is in a position to gain some advantage by reneging on the agreement. The principal then has to provide the agent with incentives to abide by the terms of the contract. We divide principal-agent problems into two classes: problems of hidden action and problems of hidden information. In hidden-action problems, the agent takes an action on behalf of the principal. The principal cannot observe the action directly, however, so he has to provide incentives for the agent to choose the action that is best for the principal. In hidden-information prob￾lems, the agent has some private information that is needed for some decision to be made by principal. Again, since the principal cannot observe the agent’s information, he has to provide incentives for the agent to reveal the infor￾mation truthfully. We begin by looking at the hidden-action problem, also known as a moral hazard problem. 3.1 The model For concreteness, imagine that the principal and the agent undertake a risky venture together and agree to share the revenue. The agent takes some 1