## Agency Problem and Agency Cost

### Background: Separation of Ownership and Control

In sole proprietorships and partnerships: owners usually manage the business themselves
In corporations: ownership (shareholders) and management (managers) are separated

### The Agency Problem

Managers (agents) should act in the best interest of shareholders (principals)
In reality, managers may pursue personal goals: higher salary, perks, personal benefits
This conflict of interest between managers and shareholders = Agency Problem
The relationship is called the Principal-Agent Relationship

### Agency Cost

The Agency Problem leads to Agency Cost — the additional cost borne by shareholders to monitor and control managerial behaviour.

Type of Agency Cost	Description
Monitoring	Cost of overseeing managerial actions (audits, oversight)
Bonding	Cost incurred by managers to guarantee they act in shareholders' interest
Opportunity	Loss from managers not acting optimally (suboptimal decisions)
Structuring	Designing contracts, compensation schemes to align interests

Worked example

### Example 1

A CEO avoids a profitable but risky investment that would benefit shareholders, because a failed project might cost him his job. This suboptimal decision creates an 'opportunity cost' type of agency cost.

### Example 2

Shareholders hire external auditors to verify that management is not manipulating financial statements. The audit fee is a 'monitoring cost' — a direct agency cost borne by the company.

⚠️ Common exam mistakes

Thinking agency problem only exists in large companies — it arises whenever there is separation of ownership and management.
Confusing agency cost types: bonding costs are paid BY managers (to give assurances), while monitoring costs are paid BY shareholders.
Assuming agency problem always involves fraud — it can simply be managers prioritising job security over shareholder value.

Reference:

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