19.1 Principal-Agent Problem

If you contract with people whose actions you cannot observe or evaluate, they may take advantage of you. If you pay someone by the hour to prepare your tax return, you do not know whether that person worked all the hours billed. If you retain a lawyer to represent you in a suit arising from an accident, you do not know whether the settlement that the lawyer recommends is in your best interest or the lawyer’s.

Of course, many people behave honorably even if they have opportunities to exploit others. Also many people honestly believe that they are putting in a full day’s work even when they are not working as hard as they might. Paul, the principal, hires Amy, the agent, to manage his ice-cream store. Paul pays Amy ...

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