Agency costs are what it costs to have one party act on another party’s behalf when their interests do not line up. The paper that named them defines them as the sum of three things: the monitoring expenditures by the principal, the bonding expenditures by the agent, and the residual loss (Jensen and Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 1976, page 6). Two of those three are spending. The third is not, and that is the part most explanations skip.
The Relationship That Produces Them
The costs come out of a specific arrangement. An agency relationship is a contract under which one or more persons, the principals, engage another person, the agent, to perform some service on their behalf which involves delegating some decision making authority to the agent (Jensen and Meckling, 1976, page 5).
The trouble starts with the delegation. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal (Jensen and Meckling, 1976, page 5). Shareholders and managers are the standard case, but the structure is general.
The Three Parts
Monitoring is what the principal spends to watch. The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent (Jensen and Meckling, 1976, page 5). An external audit, a board, a reporting package and an approval threshold all sit here.
Bonding is what the agent spends to be believable. In some situations it will pay the agent to expend resources, bonding costs, to guarantee that he will not take certain actions which would harm the principal, or to ensure that the principal will be compensated if he does take such actions (Jensen and Meckling, 1976, page 5). A covenant, a clawback and a personal guarantee are all the agent buying credibility.
Residual loss is the gap that survives both. The dollar equivalent of the reduction in welfare experienced by the principal as a result of the divergence between the agent’s decisions and the decisions that would maximize the principal’s welfare is also a cost of the agency relationship (Jensen and Meckling, 1976, page 5).
That third one never appears in any ledger. No invoice is raised for it and no account carries it, which is why a firm can cut its monitoring spend, watch the reported number fall, and be worse off.
Why They Cannot Be Driven to Zero
This is the part that makes agency costs a design problem rather than a line to cut. It is generally impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint (Jensen and Meckling, 1976, page 5).
Spend nothing on monitoring or bonding and the residual loss absorbs it. Spend heavily and the first two absorb it. The question is never how to remove the cost, only which of the three parts is the cheapest place to carry it.
Where the Term Gets Confused
The everyday sense of the word is the first confusion, and it is the more common one in a firm’s own conversations. The fee a business pays a staffing or recruiting agency is a purchase price for a service, not an agency cost in this sense. Agency here means the principal and agent relationship, not a company with agency in its name.
The second confusion narrows the idea too far. Agency costs are not only a public company and shareholder problem. Jensen and Meckling note that agency costs arise in any situation involving cooperative effort by two or more people even though there is no clear-cut principal-agent relationship, and they use the co-authoring of their own paper as the example (Jensen and Meckling, 1976, page 6). A partner delegating a return to a preparer is inside the same structure.
Common Questions
The audit fee and the board’s time are monitoring. A restrictive covenant the borrower accepts, or a guarantee the manager gives, is bonding. The value lost when a manager makes a defensible but not optimal call is residual loss, and only the first two arrive as amounts.
No, and the paper says why in one sentence: at zero cost neither party can ensure that the agent will make optimal decisions from the principal’s viewpoint (Jensen and Meckling, 1976, page 5). They can be shifted between the three parts, not removed.
If your firm is carrying more review than it can staff, you can put a real block of your own work through a trial task and grade the output before anything client facing depends on it.
