Incentive theory1 emerges with the division of labor and exchange.2 The division of labor induces the need for delegation. Historically, the first contracts probably appeared in agriculture, when landlords contracted with their tenants. It is no wonder then that Adam Smith encountered incentive problems in his discussion of sharecropping contracts (section 1.1). Delegation was also needed within firms, hence the importance of the topic in the theory of organizations (section 1.2).
For private goods, competitive markets ensure efficiency despite the decentralized nature of the information about individuals’ tastes and firms’ technologies. Implicitly, yardstick competition solves adverse selection problems and the fixed-price contracts associated with exogenous prices solve moral hazard problems. However, markets fail for pure public goods, and public intervention is thus
1The reader totally unfamiliar with this topic may benefit from reading Chapters 2 and 4 before Chapter 1 to become acquainted with some basic vocabulary.
2Actually, one could also argue that incentive issues arise within the family if one postulates different objective functions for the members of the family.