Lesson 1 of 7 · 12 min
Principal-agent relationships and agency costs
Whenever one party hires another to act on its behalf and the hired party knows more, their interests can drift apart, and the costs of that drift (monitoring plus lost value) are agency costs that investors price into their required returns.
In short
- A principal-agent (agency) relationship exists when a principal hires an agent to perform a task; it can exist with or without a contract and rests on trust, loyalty and diligence.
- In a corporation, shareholders (principal) elect directors (agent), who hire managers (another agent) to maximise shareholder value.
- Other relationships are contractual: suppliers (sell inputs), customers (buy output), lenders (provide capital under a contract); governments oversee compliance.
- Information asymmetry: agents usually know more, so principals cannot easily verify that agents act in their interest.
- Agency costs are direct (e.g. paying an external auditor) or indirect (forgone profits from lost opportunities).
- More information asymmetry means more room for conflict, so shareholders and lenders demand higher returns and risk premiums.
Unlock this lesson free for 7 days
Create a free account to get 7 days of full access — every lesson, video, flashcard, mock and the question bank. No card needed.