Definition of 'Agency Costs'
Moral hazard occurs when the agent has an incentive to take on more risk than the principal would like. For example, a company that hires a CEO may be concerned that the CEO will take on too much risk in order to increase their own compensation.
Adverse selection occurs when the agent has more information about the task than the principal. For example, a car buyer may not be able to accurately assess the condition of a used car, which gives the seller an incentive to sell a car that is in worse condition than the buyer believes.
Information asymmetry occurs when the principal and agent have different information about the task. For example, a patient may not be able to accurately assess their own health condition, which gives the doctor an incentive to recommend more tests and procedures than are necessary.
Agency costs can be significant, and they can have a negative impact on the performance of the principal-agent relationship. There are a number of ways to mitigate agency costs, including:
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* **Contracting:** The principal can specify the terms of the relationship in a contract. This can help to reduce moral hazard and adverse selection by clarifying the agent's responsibilities and by providing incentives for the agent to act in the best interests of the principal.
* **Monitoring:** The principal can monitor the agent's performance to ensure that they are meeting the terms of the contract. This can help to reduce moral hazard and adverse selection by providing the principal with information about the agent's actions.
* **Discipline:** The principal can discipline the agent if they do not meet the terms of the contract. This can help to reduce moral hazard and adverse selection by providing the agent with an incentive to act in the best interests of the principal.
Agency costs are a complex issue, and there is no single solution that will work in all cases. However, by understanding the different types of agency costs and the ways to mitigate them, the principal can improve the performance of the principal-agent relationship.
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