In the Western culture, there is a proverb that says “If you want something to be done, do it yourself”. This might imply the difficulty of hiring and managing other people to do the work. In more professional terms, these are called “agency costs” or “moral hazard”. I often heard these words on TV broadcasts. I remember a reporter who ended his report on a certain incident with the remark “Moral hazard is rampant in our society”. If I heard it correctly, I felt as if he was treating the parties involved as immoral and inhuman. Of course, depending on the case, the parties may have moral problems, but I would like to introduce the economic and managerial interpretation of these terms in relation to the classic example of corporate activities.
Agency costs and moral hazard
Agency costs and moral hazard can be simply defined as the inefficiency that arises when the hired workers do not do their work as if it were their own. The awareness of this may have existed since the beginning of human social activities, and historically, Jewish merchants in 14th-century Italy had a very sophisticated supervision system when they did business. The first economic discussion related to corporate activities was a brief mention of the operation of the South Sea Company, which had the form of a joint stock company, in A. Smith’s Wealth of Nations. In this small paragraph, Smith observed that the agents, the management, would not run the company as if it were their own unless the results of their work came back to them entirely. Since then, in the 1970s, they began to find the causes of agency costs and remedies by applying the concepts of uncertainty and information cost to agency costs. Under the recognition that uncertainty makes it difficult to measure the performance of agents, and that the measurement of the effort exerted by agents is also not easy, they have been looking for a more rigorous incentive system that both employers and employees can accept, in order to reduce agency costs. This work continues to this day.
Agency costs as a part of input costs
Agency costs should be recognized as a part of the input costs incurred in corporate operations. For example, just as a company that wants to buy timber has to pay a price for the purchased timber, the owners of the company, the shareholders, have to pay a cost that cannot be avoided when they hire professional managers to run the company on their behalf. Of course, such agency costs can be reduced by more strict monitoring and supervision. This is like finding cheaper timber by looking around the market more diligently. But such efforts also entail costs, so trying to eliminate agency costs completely without considering the monitoring costs may go against the pursuit of maximizing the profits of the company. In other words, some agency costs can be seen as the result of profit maximization.
The role of uncertainty and incentives
From an economic perspective, based on the idea that individuals pursue utility maximization according to their own interests, and adapt to the given situation, agency costs can be seen as a kind of unavoidable thing as long as there is uncertainty and costs associated with monitoring and supervision. In a way, the main culprit of agency costs is uncertainty, which is an irresistible force of nature, and agency costs are also the result of each economic agent trying to act for their own benefit in this situation.
Of course, agency costs should be minimized to increase efficiency. To achieve this, the focus should be on solving the uncertainty, which is the core of the problem, and finding a more accurate performance measurement system and a proper and strict incentive system accordingly. In order to align with the individual utility maximization, these systems should also be convincing to both employers and employees that they are beneficial to them. This is also an indispensable element.
Conclusion
I wish the reporter’s final remark had changed like this. “Our society seems to lack a performance measurement system, a reward system, and an effort to persuade the other party that ‘doing this is also beneficial to you’. That’s why moral hazard is rampant. I hope we can find a common ground where ‘we work as much as we get paid’ and ‘we get paid as much as we work’ by having a better system.”
