A short introduction to agency theory - Part 2,
Costs of Agency
This gives rise to the “costs of agency”, which are costs incurred where the principles have incentives to do things that are not in the interests of the principles. For example, managers (like any employees) may steal thing from work, of they may use company resources in a selfish and extravagant way. Have you ever seen the offices of the big bank’s CEOs? Do they really need to fly in their own private helicopter or Lear Jet? Or perhapsthe trip in a regular jumbo get the job done just as efficiently. These lavish items are called “perquisites”. A perquisites is any service or thing regarded as a special right or privilege enjoyed as a result of one's position. It’s the whole point of climbing to the top of the corporate ladder.
Costs of Agency
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This gives rise to the “costs of agency”, which are costs incurred where the principles have incentives to do things that are not in the interests of the principles. For example, managers (like any employees) may steal thing from work, of they may use company resources in a selfish and extravagant way. Have you ever seen the offices of the big bank’s CEOs? Do they really need to fly in their own private helicopter or Lear Jet? Or perhapsthe trip in a regular jumbo get the job done just as efficiently. These lavish items are called “perquisites”. A perquisites is any service or thing regarded as a special right or privilege enjoyed as a result of one's position. It’s the whole point of climbing to the top of the corporate ladder.
The Costs of Agency can also be broken down into three main areas.
- Monitoring Costs
- Bonding Costs
- Residual Loss
Simple problem – over simplified solution.
So why not just audit then? In reality it is very difficult to audit all aspects of a business operation. Moreover, an audit will only point out that the financial report was a “true and fair” representation of the “truth” – but it makes no assessment as to whether the managers made good decisions or not. You can truth report you made a profit increase of 2% this last financial year, but the harder question to ask is “was that a good outcome?” And more difficult still is “what could have they done better, and why didn’t they do that?”
The trick is to get the agents to think like they were the owners. To look at the firm as if any waste in the firm was their own waste. A simple way to do this is just pay them as if they were an owner themselves.
Small scale example: Partnership of money and experience
This is in much the same way that a person with capital meets someone with a lot of experience. They decide that they need each other and decide to split the profits. Now this is a nice idea, however when I have seen this in real life, what usually happens is that the person who started with lots of experience ends up with all the money, and the person who stated off providing the money ends up with a lot of experience.
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