ABSTRACT
Agents are problems. Their ability to op erate in their own self-interest rather than in the best interests of the firm motivates much recent literature (sec Kenneth J. Ar row, 1985). The ability of agents to operate in this manner arises from asymmetric in formation or uncertainty: the principal and the agent possess different information, and nature adds noise to the process. Two issues that arise in this type of world are moral hazard and adverse selection. The former refers to the principal’s ability to ensure that the agent’s effort level is compatible with the interests of the firm, and the latter refers to the capacity of the agent to hide information, in particular about his ability, from the principal prior to signing a con tract. In such situations, the principal has to devise a contract that will generate the cor rect incentives for the agent, forcing the agent to operate in the firm’s interests.
