Download Agency Costs

Agency Costs
Principal – agent relationships
A “principal” hires an “agent” to do a
job for the principal’s benefit.
PRINCIPAL
AGENT
Jensen and Meckling (1976):
“We define an agency relationship as a
contract under which one or more
persons (the principal(s)) engage
another person (the agent) to perform
some service on their behalf which
involves delegating some decision
making authority to the agent.”
Examples:
Patient – Doctor
Client – Lawyer
Passenger – Taxi driver
Student – Professor
Shareholders - Managers
Why hire agents?
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To access their skill or expertise
To free up your time for other things
To fulfill a legal requirement
To send a signal about yourself
The basic problem
• “If both parties to the relationship are utility
maximizers, there is good reason to believe
that the agent will not always act in the best
interests of the principal.”
Limiting agency costs
• “Monitoring” by the principal
• “Bonding” by the agent
Monitoring
• “The principal can limit divergences from his interest by
establishing appropriate incentives for the agent and by
incurring monitoring costs designed to limit the aberrant
activities of the agent . . . Montoring includes efforts to control
the behavior of the agent through budget restrictions,
compensation policies, operating rules, etc.”
• Examples:
– Watching the agent do his job
– Checking references
– Creating pay-for-performance incentives
Bonding
• “In some situations it will pay the agent to expend resources
(bonding costs) to guarantee that he will not take certain
actions which would harm the principal or to ensure that the
principal will be compensated if he does take such actions.”
• Examples:
– Paying to acquire a license or credential
– Offering a guarantee
– Wearing a clean uniform
– “Investing in reputation”
How much monitoring and bonding?
• Optimal amount of monitoring and bonding:
– up to the point where MC=MB
– too much monitoring costs more than it saves
• The principal expects and tolerates a certain amount
of “residual loss.” The agent understands the
principal’s expectations.
Residual loss
• “There will be some divergence between the agent’s
decisions and those decisions which would maximize
the welfare of the principal”
• Residual loss is not measured relative to the
principal’s expectations, nor is it measured relative to
a perfect performance by an ideal agent
Two important results
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Total agency costs equal the sum of
1. Monitoring
2. Bonding
3. Residual loss
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All agency costs are borne by the agent
(in a perfectly competitive marketplace)
Example #1
Example #2