Corporate governance problems are used to justify a comprehensive treatment of corporate finance, starting from a simple principal agent problem
inside the firm to a complex general equilibrium model with insiders, outsiders, and regulators.
In broad terms, there are two kinds of principal agent problems. Both kinds of principal agent problem do not allow the principal to observe the agents action, however there are important differences in the outcomes the principal can observe: In the first kind of problem the principal can observe what he truly cares about--how many shoes are sold- and incentives can closely replicate first best outcomes; In the second kind of problem the principal cannot observe what he truly cares about critical thinking- but only something correlated to it--test scores-.
Later analyses of the principal agent problem began with the demonstration that in more complex environments, incentives actually had to be more simple to prevent the agent "gaming" the incentive scheme [Hohnstrom and Milgrom (1987, 1991)].
The solution to a principal agent problem is to provide the agent with incentives to align his interests with those of the principal.
Moral hazard, refers to a class of principal agent problems. Moral hazard arises in a situation where the agent bears little consequence from his actions and may be careless and endanger his interests and those of others.