Final answer:
Agency problems occur when managers (agents) prioritize their own interests over those of the owners (principals), often due to information asymmetry. Agency costs are expenses used to align the interests of managers with those of the owners, including costs of monitoring, bonding, and residual losses from suboptimal decisions.
Step-by-step explanation:
Agency problems arise when there is a conflict of interest between the principals (e.g., shareholders) and agents (e.g., managers) of a company. Principals hire agents to perform tasks on their behalf, but if the agents prioritize their own interests over those of the principals, an agency problem occurs. This issue often emerges because agents have more information about their actions and the performance of the business than the principals, a situation known as information asymmetry.
Agency costs are the costs incurred in an attempt to minimize agency problems. They include monitoring costs by the principals, bonding costs incurred by the agents to guarantee that they will not take adverse actions, and the residual loss, which is the cost associated with the divergence between the agent's decisions and the most beneficial actions for the principals.
Examples of agency problems include managers pursuing personal perks over company profitability, or failing to take optimal business risks due to the desire for job security. These behaviors can result in increased operating costs, suboptimal decision-making, and ultimately, reduced profitability for the shareholders.
Agency costs are a significant aspect of corporate governance, since they represent real financial losses that companies work to minimize through various mechanisms, such as performance-based incentives, shareholder voting rights, or the threat of takeovers.