Incentives & the principal–agent problem

The principal-agent problem arises whenever one party (the principal) hires another (the agent) to act for them but can't fully observe how hard the agent works. Because effort is hidden, the agent may have reason to shirk — a situation called moral hazard, or hidden action. You can't simply pay for effort you can't see, so contracts tie pay to something observable, usually the results the effort produces. That is why compensation is often a mix of a fixed wage plus a share of the outcome — a bonus, commission, or equity: the fixed part gives security, the variable part motivates. But there is a real tension, the risk-versus-incentives trade-off: loading pay onto results sharpens motivation yet dumps risk onto the agent, who then suffers from bad luck outside their control. The best contract balances the two. It is the logic behind how salaries, bonuses, and equity are designed across the whole economy.