Agency cost
Encyclopedia
An agency cost is an economic
concept that relates to the cost incurred by an entity (such as organizations) associated with problems such as divergent management
-shareholder
objectives and information asymmetry
. The costs consist of two main sources:
Though effects of agency cost are present in any agency relationship, the term is most used in business contexts.
is generally considered to be a classic example of a principal–agent problem. The agent (the manager) is working on behalf of the principal (the shareholders), who does not observe the actions of the agent. Most importantly, even if there was no asymmetric information, the design of the manager's contract would be crucial in order to maintain the linkage between their actions and the interests of shareholders.
Information asymmetry contributes to moral hazard
and adverse selection
problems.
Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control and the different objectives (rather than shareholder maximization) the managers.
When a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies, imposing agency costs on the firm. These strategies are costly, because they lower the market value of the whole firm.
Professor Michael Jensen
of the Harvard Business School
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".
Professor Jodie Coles is one recognized academic who has made various articles picking apart the concept of 'agency costs'. She said that "Agency costs are an underpinning and fundamental flaw that a company must take into account when exercising its directors as agents of the company"
There are various actors in the field and various objectives that can incur costly correctional behaviour. The various actors are mentioned and their objectives are given below.
Bondholders know this of course, so they will have costly and large ex-ante contracts in place prohibiting the management from taking on very risky projects should they arise, or they will simply raise the interest rate which in turn increases the cost of capital for the company.
, 1969), agency costs are typically needed to explain their forms. For example, piece rates are preferred for labor tasks where quality is readily observable, e.g. sharpened sugar cane stalks ready for planting. Where effort quality is difficult to observe, e.g. the uniformity of broadcast seeds or fertilizer, wage rates tend to be used. Allen and Lueck (2004) have found farm organization is strongly influenced by diversity in the form of moral hazard such that crop and household characteristics explain the nature of the farm, even absent risk aversion. Roumasset (1995) finds that warranted intensification (e.g. due to land quality) jointly determines optimal specialization on the farm, along with the agency costs of alternative agricultural firms. Where warranted specialization is low, peasant farmers relying on household labor predominate. In high value-per-hectare agriculture, however, there is extensive horizontal specialization by task and vertical specialization between owner, supervisory personnel and workers. These agency theories of farm organization and agricultural allow for multiple shirking possibilities, in contrast to the principal-agency version of sharecropping and agricultural contracts (Stiglitz, 1974, 1988, 1988) which trades-off labor shirking vs. risk-bearing.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
concept that relates to the cost incurred by an entity (such as organizations) associated with problems such as divergent management
Management
Management in all business and organizational activities is the act of getting people together to accomplish desired goals and objectives using available resources efficiently and effectively...
-shareholder
Shareholder
A shareholder or stockholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders own the stock, but not the corporation itself ....
objectives and information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
. The costs consist of two main sources:
- The costs inherently associated with using an agent (e.g., the risk that agents will use organizational resource for their own benefit) and
- The costs of techniques used to mitigate the problems associated with using an agent (e.g., the costs of producing financial statementsFinancial statementsA financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
or the use of stock options to align executive interests to shareholder interests).
Though effects of agency cost are present in any agency relationship, the term is most used in business contexts.
Agency costs in corporate finance
The information asymmetry that exists between shareholders and the Chief Executive OfficerChief executive officer
A chief executive officer , managing director , Executive Director for non-profit organizations, or chief executive is the highest-ranking corporate officer or administrator in charge of total management of an organization...
is generally considered to be a classic example of a principal–agent problem. The agent (the manager) is working on behalf of the principal (the shareholders), who does not observe the actions of the agent. Most importantly, even if there was no asymmetric information, the design of the manager's contract would be crucial in order to maintain the linkage between their actions and the interests of shareholders.
Information asymmetry contributes to moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
and adverse selection
Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...
problems.
Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control and the different objectives (rather than shareholder maximization) the managers.
When a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies, imposing agency costs on the firm. These strategies are costly, because they lower the market value of the whole firm.
Professor Michael Jensen
Michael Jensen
Michael Cole "Mike" Jensen is an American economist working in the area of financial economics. He is currently the managing director in charge of organizational strategy at Monitor Group, a strategy consulting firm, and the Jesse Isidor Straus Professor of Business Administration, Emeritus at...
of the Harvard Business School
Harvard Business School
Harvard Business School is the graduate business school of Harvard University in Boston, Massachusetts, United States and is widely recognized as one of the top business schools in the world. The school offers the world's largest full-time MBA program, doctoral programs, and many executive...
and the late Professor William Meckling of the Simon School of Business, University of Rochester
University of Rochester
The University of Rochester is a private, nonsectarian, research university in Rochester, New York, United States. The university grants undergraduate and graduate degrees, including doctoral and professional degrees. The university has six schools and various interdisciplinary programs.The...
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
Eugene Fama
Eugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...
of University of Chicago
University of Chicago
The University of Chicago is a private research university in Chicago, Illinois, USA. It was founded by the American Baptist Education Society with a donation from oil magnate and philanthropist John D. Rockefeller and incorporated in 1890...
titled "Agency Problems and Residual Claims".
Professor Jodie Coles is one recognized academic who has made various articles picking apart the concept of 'agency costs'. She said that "Agency costs are an underpinning and fundamental flaw that a company must take into account when exercising its directors as agents of the company"
There are various actors in the field and various objectives that can incur costly correctional behaviour. The various actors are mentioned and their objectives are given below.
Management
Management, specifically the CEO, have their own objectives to pursue. The classical ones are empire-building, risk-averse investments and manipulating financial figures to optimize bonuses and stock-price-related options. The latter may just be fraudulent, but the first two are certainly not. While it erodes stockholder value, a risk-averse strategy is not by definition fraudulent.Bondholders
Bondholders typically value a risk-averse strategy since that will increase the chances of getting their investment back. Stockholders on the other hand are willing to take on very risky projects. If the risky projects succeed they will get all of the profits themselves, whereas if the projects fail the risk is shared with the bondholder.Bondholders know this of course, so they will have costly and large ex-ante contracts in place prohibiting the management from taking on very risky projects should they arise, or they will simply raise the interest rate which in turn increases the cost of capital for the company.
Board of directors
The board of directors in the literature is typically viewed as aligned with either management or the shareholders.Labour
Labour is sometimes aligned with stockholders and sometimes with management. They too share the same risk-averse strategy, since they cannot diversify their labour whereas the stockholders can diversify their stake in the equity. Risk averse projects reduce the risk of bankruptcy and in turn reduce the chances of job-loss. On the other hand, if the CEO is clearly underperforming the company is in threat of a hostile takeover which is sometimes associated with job-loss. They are therefore likely to give the CEO considerable leeway in taking risk averse projects, but if the manager is clearly underperforming, they will likely signal that to the stockholders.Other stakeholders
Other stakeholders such as government, suppliers and customers all have their specific interests to look after and that might incur additional costs. Agency costs in the government may include the likes of government wasting taxpayers money to suit their own interest, which may conflict with the general tax-paying public who may want it used elsewhere on things such as health care and education. The literature however mainly focuses on the above categories of agency costs.Agency costs in agricultural contracts
While complete contract theory is useful for explaining the terms of agricultural contracts, such as the sharing percentages in tenancy contracts (Steven N. S. CheungSteven N. S. Cheung
Steven Ng-Sheong Cheung , a Hong Kong born economist, specializes in the fields of transaction costs and property rights. Known for his work on private property rights and transaction costs, he achieved his fame with an economic analysis on China open-door policy after 1980s...
, 1969), agency costs are typically needed to explain their forms. For example, piece rates are preferred for labor tasks where quality is readily observable, e.g. sharpened sugar cane stalks ready for planting. Where effort quality is difficult to observe, e.g. the uniformity of broadcast seeds or fertilizer, wage rates tend to be used. Allen and Lueck (2004) have found farm organization is strongly influenced by diversity in the form of moral hazard such that crop and household characteristics explain the nature of the farm, even absent risk aversion. Roumasset (1995) finds that warranted intensification (e.g. due to land quality) jointly determines optimal specialization on the farm, along with the agency costs of alternative agricultural firms. Where warranted specialization is low, peasant farmers relying on household labor predominate. In high value-per-hectare agriculture, however, there is extensive horizontal specialization by task and vertical specialization between owner, supervisory personnel and workers. These agency theories of farm organization and agricultural allow for multiple shirking possibilities, in contrast to the principal-agency version of sharecropping and agricultural contracts (Stiglitz, 1974, 1988, 1988) which trades-off labor shirking vs. risk-bearing.