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Moral hazard arises when an agent's hidden actions (effort, risk-taking) are unobservable to a principal who bears the cost. The principal cannot condition payment on effort, so must use output-based contracts to incentivize. Optimal contracts balance incentive provision (high-powered) against risk imposition on risk-averse agents (low-powered). Insurance, employment, and debt contracts exemplify this tradeoff: full insurance eliminates incentive; no insurance removes the principal's control.
From your prerequisite study of moral hazard, you know the core problem: a principal (employer, insurer, lender) wants an agent (employee, policyholder, borrower) to take a costly action — exert effort, drive carefully, run the business prudently — but cannot directly observe whether they do. The question now is: what contract should the principal offer? The answer is not obvious because there are two things the principal wants simultaneously, and they pull in opposite directions.
The first goal is risk sharing. If the agent is risk-averse and the principal is risk-neutral (or has better access to diversification), efficiency requires that the principal absorb the output variability. The agent should receive a fixed payment regardless of outcomes. A salaried employee is the clearest example: the employer takes the revenue risk, the worker gets a stable paycheck. But here is the problem: once the employee's income is fixed, they bear no personal cost from low output. The effort-supply incentive disappears entirely. This is the fundamental tension.
The second goal is incentive provision. To restore effort incentives, the contract must make the agent's pay depend on output. A commission salesperson earns more when they sell more — that creates incentive. But now the agent bears outcome risk that partly reflects luck, not just effort. A good salesperson can have a bad quarter because of macro conditions. Forcing them to bear that risk is inefficient from a pure insurance standpoint. The optimal contract navigates this tradeoff: it imposes just enough output-contingent pay to induce the desired effort level, and no more. The tradeoff is often called risk vs. incentives: high-powered contracts (large pay-for-performance) provide strong incentives but impose large risk; low-powered contracts (near-flat pay) impose little risk but provide weak incentives.
Applications across domains follow the same logic. Insurance: full coverage eliminates the policyholder's incentive to prevent loss (drive carefully, lock doors). Insurers respond with deductibles and co-pays — partial loss-bearing restores prevention incentives. Debt: once a firm is deeply insolvent, shareholders bear no additional downside but capture any upside, so they have incentive to take excessive risk ("gambling for resurrection"). Equity-based executive compensation aligns manager incentives with shareholders but forces executives to hold concentrated, undiversified wealth. In each case, the contract designer faces the same tradeoff and picks an interior solution that accepts some inefficiency on one dimension to reduce inefficiency on the other.