In chapter 2, we stressed that the delegation of tasks creates an information gap between the principal and his agent when the latter learns some piece of information relevant to determining the efficient volume of trade. Adverse selection is not the only informational problem one can imagine. Agents to whom a task has been delegated by a principal may also choose actions that affect the value of trade or, more generally, the agent’s performance. By the mere fact of delegation, the principal often loses any ability to control those actions that are no longer observable, either by the principal who offers the contract or by the court of law that enforces it. Those actions cannot be contracted upon because no one can verify their value. In such cases we will say that there is moral hazard.1
The leading candidates for such moral hazard actions are effort variables, which positively influence the agent’s level of production but also create a disutility for the agent. For instance, the yield of a field depends on the amount of time that the tenant has spent selecting the best crops, or the quality of their harvesting.
1 This situation is sometimes also referred to as hidden action. See section 1.6 for the origin of the expression “moral hazard.”