Wednesday, March 28, 2012

Cost associated with taming the Agency Costs

In the last blog, we began our discussion about Agency theory and its origin. In today's blog we look at the costs associated with the prevention, and how these are resolved.

The costs incurred to reduce the possibility of agents misbehaving are called Agency Cost. These include the monitoring expenditure by principals, bonding expenditure by agents and the residual loss of the principal. There is a strong incenting to reduce these costs - for both principals and agents. The common interest is in defining a monitoring and incentive structure that produces outcomes as close as possible to being a costless information exchange.

Two sources for the agency problem are:
Moral Hazards - involves situations where much of the agent’s actions is hidden from the principal or is costly to observe. Stockholders finding it difficult to monitor the behavior of their top management team.
Adverse Selection - the agent possesses information that the principal doesn’t observe or it is very costly to obtain. This prevents the principal from fully ascertaining whether or not their interests are fully served to the best by the agent's decision.

These agency problems are generally resolved through monitoring and bonding. Monitoring involves observing the behavior and/or performance of agents. Bonding refers to the arrangement which penalizes agents for acting in ways that violate the interests of principals or reward them for achieving principal's goals. Generally these are done through contracts.

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