Adverse Selection

The second major reason that agency costs are incurred is known as adverse-selection which refers to the limited ability that stockholders have to precisely determine the competencies and priorities of executives at the  time that they are hired. Because principles cannot initially verify an executive’s appropriateness as an agent of the owners, unanticipated problem of nonoverlapping priorities between owners and agents are likely to occur.

Adverse  Selection is  an agency problem caused by the limited ability of stockholders to precisely determine the competencies and priorities of executives at the time they are hired.

Adverse selection means that as the number of employees a firm needs increases, it becomes increasingly difficult for it to find the right employees place them in appropriate positions and provide adequate supervision.

 The faster a firm grows, the less time managers have to evaluate the suitability of job candidates and the higher the chances are that an unsuitable candidate will be chosen. Selecting “ineffective or “unsuitable” employees increases the venture’s costs.