Principal Agent Problems

Limited observability creates room for an agent to choose actions that serve private goals without fully bearing the consequences for the principal. The resulting gap between delegated responsibility and observable behavior can reduce efficiency, especially when effort or decisions cannot be directly verified. Monitoring and incentive arrangements address this information problem by linking behavior more closely to the principal’s objectives.

Moral hazard and adverse selection differ mainly in timing and therefore in the remedy they suggest. Moral hazard emerges after an agreement, when the principal faces difficulty observing subsequent effort or actions. Adverse selection arises before the agreement, when private information affects the arrangement. Monitoring and incentives target the former, whereas screening helps address the latter.

Contracts, monitoring, incentives, screening, and risk-sharing address different parts of the delegation problem. Incentives encourage behavior consistent with the principal’s goals, while monitoring improves knowledge of actions or effort. Screening helps reveal relevant private information before an agreement, and risk-sharing shapes how uncertainty is allocated. Combining these tools can reduce inefficiency more effectively than relying on one mechanism alone.

Monitoring seeks to reduce the information gap by making the agent’s actions or effort more observable. Incentives instead influence the agent’s choices by connecting behavior with consequences or rewards. This distinction matters because a principal may address hidden action through better information, behaviorally aligned contracts, or both, depending on which aspect of the agent’s conduct is difficult to observe.

A practical analysis begins by identifying the delegated decision, the parties’ potentially different interests, and the information unavailable to the principal. Next, the analyst determines whether the issue occurs before or after agreement, then considers screening, monitoring, incentives, contracts, or risk-sharing. Comparing resulting behavior and efficiency clarifies which arrangement best addresses the information gap.

They arise wherever one party delegates decisions under incomplete observability. In corporate governance, owners may need to guide managers; in insurance and lending, information gaps affect agreements; and in public administration, officials may pursue objectives that do not perfectly match those of the public. These settings show why the framework applies across private and public institutions.