Moral Hazard is a problem of
. In aprincipal-agent model, the principal cannot monitorthe agents actions directly, and so the agent can actwith full discretion.
In the following model,
the principal is a firm and theagent is worker.
he worker exerts a level of effort e, which the firmcant directly observe; all it can observe is output z,which is the sum of e and a stochastic randomvariable x.
he firm needs to offer a wage that will incentivize theworker to exert the optimal level of effort.