ABSTRACT
In hidden action models, there are two parties called a principal and an agent in a vertical relationship. The principal employs the agent to undertake some action that she cannot observe. Undertaking the action is costly, so the agent has an incentive to shirk. The principal has to write a contract based on the observable output generated by the agent so as to induce him to undertake an action that is optimal from her perspective. While she runs the risk of not compensating him enough to motivate him to work hard, he runs the risk of working hard but getting inadequately compensated because hard work is not perfectly reflected in the output generated. Thus principal-agent contracts are predicated on optimal risk-sharing between the two parties. In hidden information models, typically there is one principal and many heterogeneous agents. Each agent knows his own type but the principal cannot distinguish one agent type from another.
