Lesson preview · Moral Hazard
The Principal-Agent Problem
~6 min · Free to read
The principal-agent problem formalizes moral hazard as a contract design challenge. The principal (owner, employer, shareholder) hires an agent (manager, worker, CEO) to act on their behalf. The problem: the principal cannot perfectly observe the agent’s effort, and the agent’s interests may diverge from the principal’s. The goal is to design an incentive-compatible contract that aligns the agent’s behavior with the principal’s objectives.
Key Term
Principal-Agent Problem
The principal wants high effort; the agent prefers low effort (since effort is costly). Because effort is unobservable, the principal cannot simply mandate it. Instead, the principal must design a contract that makes high effort in the agent’s self-interest — typically by tying pay to observable outcomes (output, profit, stock price).
Common incentive mechanisms include: (1) Performance pay — bonuses, commissions, piece rates tie compensation to output. (2) Stock options — align CEO incentives with shareholder value. (3) Efficiency wages — paying above-market wages makes the job valuable enough that the threat of firing deters shirking. (4) Monitoring — direct supervision, security cameras, time tracking. (5) Tournaments — promotions based on relative performance create competition among agents.
A linear incentive contract: higher means stronger incentives but also more risk on the agent. The optimal balances incentives against risk.
Worked Example
A firm owner (principal) hires a manager (agent). The manager can exert high effort (profit = 500,000 dollars) or low effort (profit = 200,000 dollars). High effort costs the manager 50,000 dollars in disutility. The owner offers: (a) flat salary of 100,000 dollars, or (b) 60,000 dollars base + 10% of profits. Which does the manager prefer? Which generates more profit?
The widget below uses the same numbers as the worked example. The firm holds the base wage fixed at 60,000 dollars and steps the commission share through five values: 0%, 10%, 20%, 50%, and 100%. At each step the manager faces a clean binary choice — work hard (earning the bonus but paying 50,000 dollars in effort) or shirk (skipping the effort cost but generating only the low-effort profit).
The left panel shows two bars: the manager’s net pay if they work hard versus if they shirk. Whichever is taller is highlighted — that’s what a rational manager picks. The right panel plots the firm’s profit at each , so you can see the whole arc — what happens when is too low (manager shirks), just right (jumps to high effort, firm profit leaps), or too high (manager works but firm overpays).
Check yourself · no marks
Why don’t firms simply set beta = 100% (give the agent all the profit)?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 4
In the principal-agent model, the fundamental problem is that:
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