Agency costs

Agency Costs are a type of internal cost that arises from, or must be paid to, an agent acting on behalf of a principal. These costs occur in the course of a business relationship when a principal hires an agent to carry out tasks. Agency costs are inherent in any Principal-Agent relationship and can be seen in various types of relationships, such as between shareholders (principal) and management (agent), or between the owners of a business (principal) and the managers of the business (agent).

Overview

Agency costs are part of the transaction costs that are incurred to resolve conflicts between principals and agents. They are categorized into two types: the costs of drafting, negotiating, and safeguarding an agreement (contracting costs), and the costs that arise due to inefficiencies that occur when an agent does not fully comply with the agreement (residual loss).

Contracting Costs

Contracting costs are the costs associated with the creation and enforcement of a contract between the principal and the agent. These costs include the time and resources spent on negotiating the contract, the costs of monitoring and enforcing the agreement, and the costs of bonding to ensure that the agent does not deviate from the agreement.

Residual Loss

Residual loss refers to the inefficiencies that occur when the agent does not act in the best interest of the principal. This can occur due to moral hazard, where the agent takes on excessive risk because the consequences of failure will fall on the principal, or due to adverse selection, where the agent has more information than the principal, leading to suboptimal decision making.

Mitigation of Agency Costs

There are several strategies to mitigate agency costs. These include proper incentive alignment, where the agent's rewards are tied to the principal's goals, and monitoring, where the principal keeps a close watch on the agent's actions. Other strategies include contract design, where the terms of the agreement are structured to minimize conflicts of interest, and corporate governance, which involves the systems and processes that control and direct a corporation.

See Also

• Principal-agent problem
• Transaction costs
• Moral hazard
• Adverse selection
• Corporate governance