Explanation on agency relationship problems and costs

explanation on agency relationship problems and costs

An agency cost is an economic concept concerning the fee to a "principal when the principal chooses or hires an "agent" to act on its behalf. Because the two parties have different interests and the agent has more the Chief Executive Officer is generally considered to be a classic example of a principal–agent problem. Agency problem and agency cost. 1. By, Nidhish Thampi P PGDM – A; 2. Agency problem is the likelihood that managers may place. Agency costs are incurred when attempting to control agency problems. Agency problems arise when the agent makes decisions consistent with the.

Agency cost

Because bondholders know this, they often have costly and large ex-ante contracts in place prohibiting the management from taking on very risky projects that might arise, or they will simply raise the interest rate demanded, increasing the cost of capital for the company.

Board of directors[ edit ] In the literature, the board of directors is typically viewed as comprising both the management and the shareholders and in some cases, the management could also be part of the shareholders.

Labour[ edit ] Labour is sometimes aligned with stockholders and sometimes with management. They too share the same risk-averse strategy, since they cannot diversify their labour whereas the stockholders can diversify their stake in the equity.

explanation on agency relationship problems and costs

Risk averse projects reduce the risk of bankruptcy and in turn reduce the chances of job-loss. On the other hand, if the CEO is clearly underperforming then the company is in threat of a hostile takeover which is sometimes associated with job-loss. They are therefore likely to give the CEO considerable leeway in taking risk averse projects, but if the manager is clearly underperforming, they will likely signal that to the stockholders.

Other stakeholders[ edit ] Other stakeholders such as the government, suppliers and customers all have their specific interests to look after and that might incur additional costs.

Agency costs in the government may include the likes of government wasting taxpayers money to suit their own interest, which may conflict with the general tax-paying public who may want it used elsewhere on things such as health care and education. The literature however mainly focuses on the above categories of agency costs.

Successful innovation is particularly dependent on employees' willingness to take risks. In cases with extreme incentive intensity, this sort of behavior can create catastrophic organizational failure. If the principal owns the firm as part of a diversified portfolio this may be a price worth paying for the greater chance of success through innovation elsewhere in the portfolio. If however the risks taken are systematic and cannot be diversified e.

Deferred compensation[ edit ] Tournaments represent one way of implementing the general principle of "deferred compensation", which is essentially an agreement between worker and firm to commit to each other.

Under schemes of deferred compensation, workers are overpaid when old, at the cost of being underpaid when young. Salop and Salop argue that this derives from the need to attract workers more likely to stay at the firm for longer periods, since turnover is costly.

Alternatively, delays in evaluating the performance of workers may lead to compensation being weighted to later periods, when better and poorer workers have to a greater extent been distinguished.

Workers may even prefer to have wages increasing over time, perhaps as a method of forced saving, or as an indicator of personal development. For example Akerlof and Katz Overall, the evidence suggests the use of deferred compensation e. Other applications[ edit ] The "principal—agent problem" has also been discussed in the context of energy consumption by Jaffe and Stavins in They were attempting to catalog market and non-market barriers to energy efficiency adoption.

In efficiency terms, a market failure arises when a technology which is both cost-effective and saves energy is not implemented.

Jaffe and Stavins describe the common case of the landlord-tenant problem with energy issues as a principal—agent problem. Is the agent the landlord and the principal the tenant, because the landlord is "hired" by the tenant through the payment of rent?

As Murtishaw and Sathaye, point out, "In the residential sector, the conceptual definition of principal and agent must be stretched beyond a strictly literal definition. In this case, there is also little incentive for the tenant to make a capital efficiency investment with a usual payback time of several years, and which in the end will revert to the landlord as property.

Since energy consumption is determined both by technology and by behavior, an opposite principal agent problem arises when the energy bills are paid by the landlord, leaving the tenant with no incentive to moderate her energy use. This is often the case for leased office space, for example.

The energy efficiency principal agent problem applies in many cases to rented buildings and apartments, but arises in other circumstances, most often involving relatively high up-front costs for energy-efficient technology.

Though it is challenging to assess exactly, the principal agent problem is considered to be a major barrier to the diffusion of efficient technologies.

Agency cost - Wikipedia

This can be addressed in part by promoting shared-savings performance-based contracts, where both parties benefit from the efficiency savings. The issues of market barriers to energy efficiency, and the principal agent problem in particular, are receiving renewed attention because of the importance of global climate change and rising prices of the finite supply of fossil fuels.

The principal—agent problem in energy efficiency is the topic of an International Energy Agency report: The problem manifests itself in the ways middle managers discriminate against employees who they deem to be " overqualified " in hiring, assignment, and promotion, and repress or terminate " whistleblowers " who want to make senior management aware of fraud or illegal activity.

This may be done for the benefit of the middle manager and against the best interest of the shareholders or members of a non-profit organization.


Public officials are agents, and people adopt constitutions and laws to try to manage the relationship, but officials may betray their trust and allow themselves to be unduly influenced by lobby groups or they may abuse their authority and managerial discretion by showing personal favoritism or bad faith by hiring an unqualified friend or by engaging in corruption or patronagesuch as selecting the firm of a friend or family member for a no-bid contract.

The problem arises in client—attorney, probate executor, bankruptcy trustee, and other such relationships.

explanation on agency relationship problems and costs

The second agency problem involves the conflict between, on one hand, owners who possess the majority or controlling interest in the firm and, on the other hand, the minority or non-controlling owners.

Here the non-controlling owners can be thought of as the principals and the controlling owners as the agents, and the difficulty lies in assuring that the former are not expropriated by the latter.

explanation on agency relationship problems and costs

Thus if minority shareholders enjoy veto rights in relation to particular decisions, it can give rise to a species of this second agency problem.

Similar problems can arise between ordinary and preference shareholders, and between senior and junior creditors in bankruptcy when creditors are the effective owners of the firm.

explanation on agency relationship problems and costs

The third agency problem involves the conflict between the firm itself—including, particularly, its owners—and the other parties with whom the firm contracts, such as creditors, employees, government and customers.

Here the difficulty lies in assuring that the firm, as agent, does not behave opportunistically toward these various other principals—such as by expropriating creditors, exploiting workers, or misleading consumers.

Shareholders invest funds in high risk investments. Thiese investments can eithr succeed and get high returns or fail leading to huge loses.

Conflict therefore can arise in the following instances. Companies operate in the environment with mandate from the government.

  • Principal–agent problem

The owners may affect the position of the government by engaging in illegal business activities, tax, failure to take part in CSR and avoiding investment in certain areas of the economy. The auditors may affect the interest of the shareholders causing agency problems in the following ways: