Why Does it Matter that Beliefs and Valuations be Correctly Represented?

Abstract

This paper contains an analysis of a simple principal-agent problem illustrating possible problems that may arise when the prinicpal ascribes to the agent subjective probabilities and utilities that are implied by the subjective expected utility model but do not represent the agent's beliefs and valuations. In particular, it is possible that an incentive contract designed by the principal indices the agent to choose an action that is not in the principal's best interest.principal agent theory;moral hazard