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Asymmetric Information 587

educational attainment serves as an important signal, distinguishing persons of

different productivities.

We sum up this discussion with two comments. First, for signaling to work,

high-quality firms or individuals must have an incentive to use the signal; their

lower-quality counterparts do not. This typically requires lower cost of signal-

ing for the former group than for the latter. Second, signaling is not costless.

Students sometimes pursue college or higher degrees simply to earn a “job cre-

dential” rather than for the education itself. As long as signaling is part of the

equation, individuals will have an incentive to overinvest in education.^6

Principals, Agents, and Moral Hazard

The preceding examples share the feature that the actions of one party (the

one with better information) affect the welfare of a second party. Knowing their

plans for starting a family, a couple decides whether to enroll in the health

benefits program. Individuals who know their own talents make education and

job plans that affect employers. These relationships often are referred to as

principal-agentproblems. The party who takes the action is the agent; the

affected party—who has only limited information about and control over the

agent—is the principal.

Examples of principal-agent relationships abound. A physician (agent),

who has superior knowledge, takes actions that affect the welfare of his or

her patient (principal). A supplier (agent) may or may not live up to his or

her contractual obligations to serve a buyer (principal). Within the firm,

employees (agents) may not have the incentives to act according to their

employer’s (principal’s) wishes. And although the law requires that man-

agement act in the best interests of stockholders, the stockholders typically

lack the information to know whether management is indeed making the

right decisions.

The problem of moral hazardoccurs when an agent has incentives to act

in its own interests, contrary to the interests of the principal. The following

principal-agent setting combines the dual problems of moral hazard and

adverse selection.

A BUILDING CONTRACT Because of its spectacular growth, a business firm

(the principal) has decided to proceed with a new regional headquarters build-

ing. It has entered into a building contract with a construction firm (the agent)

with which it has worked in the past. Based on preliminary architectural plans,

the estimate of the final completion cost is $6.5 million. Both sides acknowledge

(^6) In contrast, if all firms had perfect knowledge of all persons’ productivities, there would be no sig-
naling role. An individual would increase his or her level of education if and only if the long-term
benefit (in terms of increased productivity and wages) exceeded the additional cost of schooling.
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