Agents acting in the interests of a principal present the danger of a moral hazard when agents can behave unobserved in their own self-interest. The separation of ownership and control in the modern corporation makes perfect monitoring of agents impossible due to cost constraints. However, some monitoring and other processes can reduce moral hazards by making agents accountable for their actions and the outcomes of these actions.
Agency costs refer to any expenditure on the part of the principal in attempting to avoid a moral hazard on the part of the agent. These costs include monitoring, incentives, punishments, accounting procedures, budgetary constraints, and even technical devices such as video cameras and computer software.
The Principle of Incremental Benefits suggests that the value of alternatives can be measured by the increased benefits of choosing one alternative over another. For example, if one share of stock is expected to return 10% and another is expected to return 12%, the expected incremental benefit of choosing the second stock is 2%. However, costs can be incremental too. Agency costs are the incremental costs associated with working through others in a principal-agent relationship rather than the principals doing the work themselves.
Agency costs include not only the monitoring and regulatory costs, but the costs associated with agents extracting value from the owners by acting in a self-interested manner. These self-interested behaviors include theft of company supplies, use of company resources for personal gain, and even the costs that can’t be measured such as loss of customer trust if a manager is publicly found to be behaving unscrupulously with company assets.
The goal of a principal is minimize agency costs of the principal-agent relationship. This includes an analysis of the costs of setting up a contract with the agent and the cost of occasion misbehaving. When the costs of misbehaving are higher than the cost of setting up a monitoring scheme, the monitoring is justified. Again, the Principle of Incremental Benefits states that the premium of choosing one alternative over another is the real benefit of the decision.
Agency costs are any expenditure or loss associated with the principal-agent relationship. Although these costs can be expected, setting up a contract with an agent that minimizes agency costs is an owner’s first priority. Often, individual stockholder as owners of a corporation do not have direct control over the agency contract. However, as stockholders they do have certain rights granted to them such as voting rights that allow some say on the contents of the contract. Wise investors are aware of the current contractual agreements between owners and managers and figure this factor in when valuing a company. Just as the expected return on an investment is a major consideration when choosing which stocks to buy, the expected losses due to agent misconduct is a factor in valuing a company’s profitability.
This post is part of the series: Principal-Agent Relationships
Corporations have a multitude of Principal-Agent Relationships as the Set-of-Contracts view of the firm implies. Agency problems, monitoring, moral hazards, and agency costs are often evaluated by investors to determine the risk of owning stock in a corporation.