Basically, there is a cost associated with having an agent working for a principal in that the agent will, even with the best intentions, not do it the same way as the principal would. This difference can produce minor costs in the case of an agent that keeps the principal in mind when making decisions or a major cost as we have seen with many CEO’s and others as they aren’t concerned with anyone except themselves. Essentially, it deals with the separation of ownership and control.
Moral hazard as an offshoot of Agency theory deals with the decision making of agent being more risky because the consequences have been shifted to third party which is advantageous to the risk taker and, more importantly, potentially disastrous to the party that has assumed the risk. We will get into this more when we deal with FDIC and bank depositor insurance.