Agency Cost

CORE DEFINITION

Agency cost is an economic concept that refers to the costs associated with the relationship between a 'principal' (an organization, individual, or group of people) and an 'agent'. The agent is authorized to make decisions on behalf of the principal. However, the two parties may have different motivations, and the agent typically has more information (see information asymmetry). The principal cannot directly ensure that the agent always acts in the principal's best interest. This potential divergence of interests leads to agency costs. Common examples of such costs include when company management (the agent) purchases other companies to expand their own power, or spends money on wasteful and unnecessary projects rather than maximizing company value, with the consequences borne by shareholders (the principal); or when politicians (the agent) pass legislation to help major campaign sponsors rather than the constituents they are responsible to, with the impact felt by voters. Although the effects of agency costs exist in any agency relationship, the term is most commonly used in business contexts. In new institutional economics, agency costs refer to all costs incurred in the context of a principal-agent relationship.