Agency costs are those that arise due to the conflict of interest between principal and agent.
The principal is the person who hires and the agent is the one hired. The latter performs his work on behalf of the former. Therefore, both agent and principal can be an individual or organization of any kind.
Characteristics of the problem
A principal may be interested in hiring another person to carry out activities for him for different reasons. For example, you might feel that you are not empowered enough to do it yourself. Also, you may be motivated to do other activities without neglecting your other responsibilities.
Regardless of the above, the contract generates costs, since the principal does not have perfect information about his counterpart. An example of this situation is when the shareholders of a company hire managers to run it. On the one hand, shareholders may be interested in maximizing the share price to increase their wealth. Similarly, they would be interested in distributing more dividends. On the other hand, managers would be more interested in the growth and consolidation of the company. This does not necessarily generate growth in the price of the shares or higher dividends in the short term. Consequently, a conflict is generated over the priorities of the parties involved.
It is common for this relationship to be formalized through a contract. This minimizes the risk of conflict of interest, since the contract must contain the guidelines that regulate the relationship.
In this sense, they undertake to cooperate in carrying out certain activities. This applies to the administration of a company, the repair of a house or the hiring of a broker, for example.
How to reduce the cost of agency?
There are different methods that are used to minimize agency costs.
Some of them are:
- Control agent activities : This could be a solution when tasks are easy to measure and monitor. However, the more complicated it is to control, the more costs it generates to monitor. For example, you can set goals for income or levels of production.
- Grant incentives : The objective in this case is to ensure that agent and principal have the same interests. For example, through the granting of shares and options, and the payment of commissions. Efficiency pay can also be considered.
In general, the risk of conflict is minimized by reducing information asymmetry. That is, the clearer the agent’s interests are, the less costs the relationship entails. In addition, the incentives have the objective that each individual, in pursuit of their own interests, reaches the objective of the group.