Hidden Action and Incentives

A common economic occurrence is the following: Two parties, principal and agent, are in a situation—typically of their choosing—in which actions by the agent impose an externality on the principal. Not surprisingly, the principal will want to influence the agent’s actions. This influence will often take the form of a contract that has the principal compensating the agent contingent on either his actions or the consequences of his actions. Table 1 lists some examples of situations like this. Note that, in many of these examples, the principal is buying a good or service from the agent. That is, many buyer-seller relationships naturally fit into the principal-agent framework. This note covers the basic tools and results of agency theory in this context.