Principal and agent want to write a contract, such that the agent borrows from the principal, realizes a random return, and pays something back.
Monitoring uses real resources.
If he does default, the lender monitors to find out the size of the total product, and takes it all . This is equivalent to , s.t. Incentive compatibility implies that the creditor has to monitor in the low states, and not monitor in the high states. Otherwise you could understate your earnings without penalty. Either way, you can reduce your monitoring costs to almost nothing.