Agency costs definition

What are Agency Costs?

Agency costs are the costs associated with the differences between the intentions of an agent and a principal, where the principal does not have complete control over the situation. These differences in viewpoint can lead to substantial additional costs or the loss of value. For example, when the managers of a company take the business in a direction that is disagreeable to shareholders, the shareholders are more likely to sell off their shares in the business, which reduces the market value of the shares. This decline in value is an agency cost.

Indirect Agency Costs

There are indirect impacts resulting from agency costs, which are lost opportunities. For example, the management team of a business elects not to engage in a new project because it will make their jobs redundant, even though it will trigger a large increase in value for the shareholders. In this case, the exact amount of the agency cost cannot be quantified, but there is a clear cost being incurred.

Examples of Agency Costs

As an example of agency costs, shareholders may want to increase earnings per share by focusing on cost cutting, while managers are more intent on spending money to increase their perks. Or, the senior managers of a business engage in reporting fraud in order to increase the share price and cash in their stock options, after which the stock price drops, harming shareholders. Another relationship that can result in agency costs is between elected politicians and voters, where politicians may take actions that are detrimental to the interests of voters.