Agency cost
Agency costs are the losses and expenses that arise from conflicts of interest between principals and their agents.
Delegation is never free. The losses from agents not serving principals, plus the cost of trying to make them, are agency costs.
Agency costs are the costs that arise from the conflicts of interest between principals and the agents who act on their behalf, comprising both the losses from agents pursuing their own goals and the expense of monitoring and incentivising them to do otherwise. They are the price of the principal-agent problem.
The three components
Agency costs are usually broken into three parts. Monitoring costs are what the principal spends watching and controlling the agent, through audits, oversight, and reporting. Bonding costs are what the agent spends, or accepts, to reassure the principal of good behaviour, such as submitting to constraints or putting their own stake at risk. And the residual loss is the value still lost because, despite all this, the agent's actions never perfectly serve the principal. Together these capture the full cost of the relationship.
Where they fall heaviest
Agency costs are largest where interests diverge sharply and monitoring is hard. The separation of ownership and control in large firms is the classic source: dispersed shareholders find it costly to monitor managers, who may pursue their own interests, so firms incur the costs of boards, audits, incentive pay, and the residual loss of imperfect alignment. Debt carries its own agency costs, as lenders guard against borrowers taking excessive risk. Any relationship of delegation, in firms, finance, or government, generates them.
Reducing them, at a cost
Much of corporate governance and contract design is an attempt to minimise total agency costs. But there is a trade-off: tighter monitoring and stronger incentives reduce the residual loss but raise monitoring and bonding costs, so the aim is to minimise the sum, not any single part. Perfect alignment would cost more than it saves; some residual loss is efficient. This is why governance settles on imperfect but cost-effective arrangements rather than eliminating the conflict entirely.
Agency costs put a price on the principal-agent problem, turning an abstract conflict of interest into a concrete burden that firms and economies bear. They explain the expense of governance, oversight, and incentive design, and why the relationship between owners and managers, or any principal and agent, is never frictionless but always carries a cost that good institutions seek to contain rather than abolish.