Question

a. What are agency costs? Why do these tend to increase in severity, as a company grows larger?

b. Think back to the last time you ate at an expensive restaurant where you paid the bill. Now think about the last time you ate at a similar restaurant, but your parents paid the bill. Did you order more food (or more expensive food) when your parents paid? Explain how this relates to the agency problem in corporations.

c. You are the CEO of a company and you are considering entering into an agreement to have your company buy another company. You think the price might be too high, but you will be the CEO of the combined, much larger company. You know that when the company gets bigger, your pay and prestige will increase. What is the nature of the agency conflict here, and how is it related to ethical considerations?

Answer 1

a. Agency cost is the cost that is incurred by the company due to agency conflict. The agency conflict arises due to the difference between the principal and the agent. The principal assigns some work and responsibilities to the agent. The agent may or may not follow the instructions of the principal. This will lead to difference of opinion and conflict. The conflict will lead to increased expenses and costs in carrying out the activity. Such costs are known as agency costs. The agency cost increases as the size of the company increases. This is because the number of people involved will be more and the work as well as responsibilities of the agent will also be more. So there are more chances of agency conflicts and agency costs.

b. The last time we ate at an expensive restaurant I ordered more quantity as well as variety of food than I would have ordered if I was paying the bill. This happens because there is a feeling that the money will be spent from some other person's pocket and so I can order as much as I want to. The similar issue arises in a company when the agent feels that he or she does not belong to the company and that they can extract as much money as they want from the company. This leads to increased agency cost. The personal goals of the agent may become more important to the agent than the goals of the company.

c. The conflict here is also between the personal goal (more pay, prestige etc) and the goal of the company (increased shareholder value). The ethical consideration should be that to ensure that the buying of another company will be beneficial to the company in the long run or not. The amount of money that will be spent will be a big amount. Therefore the cost benefit analysis should be done from the company's perspective and then the decision should be taken.