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Concept
Agency cost
Summary
An agency cost is an economic concept that refers to the costs associated with the relationship between a "principal" (an organization, person or group of persons), and an "agent". The agent is given powers to make decisions on behalf of the principal. However, the two parties may have different incentives and the agent generally has more information. The principal cannot directly ensure that its agent is always acting in its (the principal's) best interests. This potential divergence in interests is what gives rise to agency costs.
Common examples of this cost include:
according to the Friedman doctrine, the cost borne by shareholders (the principals) when corporate management (the agent) buys other companies to expand its power, or spends money on vanity projects, instead of maximizing the value of the corporation;
the cost borne by the voters of a politician's district (the principals) when the politician (the agent) passes legislation helpful to large contributors to their campaign rather than the voters.
Though effects of agency cost are present in any agency relationship, the term is most used in business contexts.
Professor Michael Jensen and the late Professor William Meckling of the Simon School of Business, University of Rochester wrote an influential paper in 1976 titled "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure". Professor Jensen also wrote an important paper with Eugene Fama of University of Chicago titled "Agency Problems and Residual Claims". These works categories agency costs into three main sources:
Monitoring costs: Costs borne by the principal to mitigate the problems associated with using an agent. They may include gathering more information on what the agent is doing (e.g., the costs of producing financial statements or carrying out audits) or employing mechanisms to align the interests of the agent with those of the principal (e.g.
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