20. The Principal-Agent Problem

What does a contract look like when effort is unobservable — find the optimal performance pay where incentive compatibility meets participation, then decide whether the incentives are worth buying.

• Moral Hazard and Incentives — This scene designs a contract when the boss cannot watch the work. A flat wage alone gives no reason to work hard. Pay must hang on the outcome. Good results need a bonus on top. Two conditions must hold at once. Working hard must beat slacking off. And the job must be worth taking at all. The less the worker fears risk, the gentler the bonus slope. It is a tug-of-war between sharing risk and pushing effort. For example, you run a 🏪 snack shop and leave a part-timer alone. You cannot see how hard they work. So you do not fix the wage. On days the shop earns more 💰 money, you pay a bonus. Then the part-timer works hard on their own.
• Which Effort to Implement — This scene asks whether high effort is worth buying. Making someone work hard is never free. As the effort cost rises, the profit from high effort falls. The profit from low effort stays flat. Where the two profits meet is the cutoff. Incentives pay only on the cheap side of it. The effort cost is exactly the risk premium you must cover. For example, a parent sets the 💰 allowance for an errand. A trip to the nearby 🏪 shop takes 1,000 won. A far shop is tiring and needs more. If the price gets too high, going in person is cheaper. Hard effort is worth buying only while it stays cheap.