Agency cost

Agency costs are the total losses that arise when a principal delegates authority to an agent whose interests diverge from the principal's. First formalized by economists in 1976, agency costs consist of three components: monitoring costs (what the principal spends to observe the agent), bonding costs (what the agent spends to demonstrate good faith), and residual loss (the remaining divergence that no contract can eliminate).

The concept is foundational to understanding the economics of organizations. Every firm, government bureau, and nonprofit is a nexus of principal-agent relationships, each with its own agency costs. The size and structure of organizations can be understood as responses to the problem of minimizing these costs — though as the public choice theory literature demonstrates, the agents who manage the organization often have incentives to increase rather than decrease agency costs, since larger budgets and more staff enhance their power and security.

Agency costs are not merely an economic concept; they are a measure of the friction inherent in all delegated authority. The lower bound of agency costs in any system is never zero.