There are many settings in which one economic actor (the principal) delegates authority and/or responsibilities to an agent to act on his behalf. The primary reason for doing so is that the agent has an advantage in terms of expertise or information. This informational advantage, or information asymmetry, poses a problem for the principal—how can the principal be sure that the agent has in fact acted in her best interests? Can a contract be written deﬁning incentives in such a way that the principal can be assured that the agent is taking just the action that she would take, had she the information available to the agent?
Solving this problem is a matter of some concern for patients dealing with their doctors, clients dealing with their lawyers, etc. It is also a crucial concern for business ﬁrms dealing with their employees. Especially in the twenty-ﬁrst century, employees are often hired precisely because they have information available that is unavailable to the managers of a ﬁrm, who changes or implements new ways of work (Innovation), making sure that employee expertise is put to work in the interest of the ﬁrm can make the difference between success and bankruptcy–as illustrated by the performance of Google Corporation and their success.
The key common aspect of all those contracting settings is that the information gap between the principal and the agent has some fundamental implications for the design of the bilateral contract they sign.
In order to reach an efficient use of economic resources, this contract must elicit the agent´s private information. This can only be done by giving up some information rent to the privately informed agent. Generally, this rent is costly to the principal. This cost or payment is what is known as Monitoring Cost, on which the Principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent (Jensen, 1976, pg. 5).
And just like in any other trade, the Principal is giving something in exchange of the actions and decisions of the Agent; we can say that the Monitoring Cost is an action with its own reaction:Bonding Cost. This is the Welfare the Agent is willing to take, on behalf of the Principal, to limit or restrict his own actions, therefore reducing the deviation from the Principal's interests. These costs guarantee that the Agent will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions (Jensen, 1976, pg. 5).
Nevertheless there will always be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal. The equivalent of the reduction in welfare experienced by the principal as a result of this divergence is what we refer as the Residual Loss (Jensen, 1976, pg. 5).
But as said on the beginning, this deal is because of a lack of information or expertise of the Principal in comparison with the Agent. This lead us to the Asymmetrical relationship. Asymmetrical relationship refers to the fact that the Agent may have more information than the Principal, leading to the fact that the Principal may not know to what degree are the actions of the Agent in the Principal's own interests. Given the self-interest of the Agent, he may or may have not behaved as agreed (Eisenhardt, 1989, 61). Information is asymmetric because the agent, of course, knows which decision he is going to make (Spremann, 1987, pg. 4).
This Asymmetrical relationship leads into a field of risk and uncertainty represented by the dilemma of Moral Hazard and Adverse Selection.
Moral hazard is a situation where the behavior of one party may change to the detriment of another after the transaction has taken place. A party makes...