The following statement appears in “Agency Costs and Unregulated Banks: Could Depositors Protect Themselves?” by Catherine England (Cato Journal 7, no, 3 [Winter 1988]):
The agency costs literature argues that both agents and principals are aware of the potential conflicts of interest and abuses that can arise in an agency relationship. But neither group is expected to passively accept the limitations imposed by the potential problems and inefficiencies. The recognition of agency costs creates incentives for both groups to take steps to minimize and control the problem. To protect their interests, principals have reason to develop and incorporate contractual terms designed to channel the behavior of agents in desirable directions and/or to limit their ability to engage in unacceptable activities. In addition, principals setting a value on agents’ services will consider the costs associated with the principal/agent relationship and reduce accordingly the compensation that would be paid to agents in a world of perfect information. Faced with the possibility of reduced compensation, agents will not only agree to contractual terms that reassure principals, but will also develop mechanisms that tend to make principals more confident.
a. What are agency costs?
b. What can principals do to reduce agency costs?