8. Principals and Agents

This chapter familiarizes readers with the common properties of principal-agent models and their application to many seemingly unrelated economic interactions, from a buyer purchasing a good of variable quality to a landlord renting an apartment. The problems below concern hidden action models, where the agent's actions are not verifiable and thus not subject to a complete contract.

The models in this chapter illustrate the ways in which the lack of a complete contract fundamentally changes how markets work, even in perfectly competitive equilibrium. Key outcomes include non-clearing markets, agents receiving enforcement rents conferred on them by profit maximizing principals, principals exercising power over agents, and the influence of agents' preferences on principals' payoffs. The resulting allocation is often neither technically- nor Pareto-efficient, despite the absence of impediments to or the usual uncompensated external effects.