Theory of the Firm Managerial Behavior,Agency Cost

TheoryoftheFirm:ManagerialBehavior,AgencyCostsandOwnershipStructureMichaelC.JensenHarvardBusinessSchoolandWilliamH.Meckling*UniversityofRochester1.Introduction1.1.MotivationofthePaperInthispaperwedrawonrecentprogressinthetheoryof(1)propertyrights,(2)agency,and(3)financetodevelopatheoryofownershipstructureforthefirm.Inadditiontotyingtogetherelementsofthetheoryofeachofthesethreeareas,ouranalysiscastsnewlightonandhasimplicationsforavarietyofissuesintheprofessionalandpopularliteratureincludingthedefinitionofthefirm,the“separationofownershipandcontrol,”the“socialresponsibility”ofbusiness,thedefinitionofa“corporateobjectivefunction,”thedeterminationofanoptimalcapitalstructure,thespecificationofthecontentofcreditagreements,thetheoryoforganizations,andthesupplysideofthecompletenessofmarketsproblems.Ourtheoryhelpsexplain:1.whyanentrepreneurormanagerinafirmwhichhasamixedfinancialstructure(containingbothdebtandoutsideequityclaims)willchooseasetofactivitiesforthefirmsuchthatthetotalvalueofthefirmislessthanitwouldbeifhewerethesoleownerandwhythisresultisindependentofwhetherthefirmoperatesinmonopolisticorcompetitiveproductorfactormarkets;2.whyhisfailuretomaximizethevalueofthefirmisperfectlyconsistentwithefficiency;3.whythesaleofcommonstockisaviablesourceofcapitaleventhoughmanagersdonotliterallymaximizethevalueofthefirm;4.whydebtwasrelieduponasasourceofcapitalbeforedebtfinancingofferedanytaxadvantagerelativetoequity;5.whypreferredstockwouldbeissued;6.whyaccountingreportswouldbeprovidedvoluntarilytocreditorsandstockholders,andwhyindependentauditorswouldbeengagedbymanagementtotestifytotheaccuracyandcorrectnessofsuchreports;7.whylendersoftenplacerestrictionsontheactivitiesoffirmstowhomtheylend,andwhyfirmswouldthemselvesbeledtosuggesttheimpositionofsuchrestrictions;8.whysomeindustriesarecharacterizedbyowner-operatedfirmswhosesoleoutsidesourceofcapitalisborrowing;9.whyhighlyregulatedindustriessuchaspublicutilitiesorbankswillhavehigherdebtequityratiosforequivalentlevelsofriskthantheaveragenonregulatedfirm;10.whysecurityanalysiscanbesociallyproductiveevenifitdoesnotincreaseportfolioreturnstoinvestors.1.2TheoryoftheFirm:AnEmptyBox?Whiletheliteratureofeconomicsisrepletewithreferencestothe“theoryofthefirm,”thematerialgenerallysubsumedunderthatheadingisnotactuallyatheoryofthefirmbutratheratheoryofmarketsinwhichfirmsareimportantactors.Thefirmisa“blackbox”operatedsoastomeettherelevantmarginalconditionswithrespecttoinputsandoutputs,therebymaximizingprofits,ormoreaccurately,presentvalue.Exceptforafewrecentandtentativesteps,however,wehavenotheorywhichexplainshowtheconflictingobjectivesoftheindividualparticipantsarebroughtintoequilibriumsoastoyieldthisresult.ThelimitationsofthisblackboxviewofthefirmhavebeencitedbyAdamSmithandAlfredMarshall,amongothers.Morerecently,popularandprofessionaldebatesoverthe“socialresponsibility”ofcorporations,theseparationofownershipandcontrol,andtherashofreviewsoftheliteratureonthe“theoryofthefirm”haveevidencedcontinuingconcernwiththeseissues.Anumberofmajorattemptshavebeenmadeduringrecentyearstoconstructatheoryofthefirmbysubstitutingothermodelsforprofitorvaluemaximization,witheachattemptmotivatedbyaconvictionthatthelatterisinadequatetoexplainmanagerialbehaviorinlargecorporations.Someofthesereformulationattemptshaverejectedthefundamentalprincipleofmaximizingbehavioraswellasrejectingthemorespecificprofit-maximizingmodel.Weretainthenotionofmaximizingbehavioronthepartofallindividualsintheanalysisthatfollows.1.3PropertyRightsAnindependentstreamofresearchwithimportantimplicationsforthetheoryofthefirmhasbeenstimulatedbythepioneeringworkofCoase,andextendedbyAlchian,Demsetz,andothers.AcomprehensivesurveyofthisliteratureisgivenbyFurubotnandPejovich(1972).Whilethefocusofthisresearchhasbeen“propertyrights”,thesubjectmatterencompassedisfarbroaderthanthattermsuggests.Whatisimportantfortheproblemsaddressedhereisthatspecificationofindividualrightsdetermineshowcostsandrewardswillbeallocatedamongtheparticipantsinanyorganization.Sincethespecificationofrightsisgenerallyaffectedthroughcontracting(implicitaswellasexplicit),individualbehaviorinorganizations,includingthebehaviorofmanagers,willdependuponthenatureofthesecontracts.Wefocusinthispaperonthebehavioralimplicationsofthepropertyrightsspecifiedinthecontractsbetweentheownersandmanagersofthefirm.1.4AgencyCostsManyproblemsassociatedwiththeinadequacyofthecurrenttheoryofthefirmcanalsobeviewedasspecialcasesofthetheoryofagencyrelationshipsinwhichthereisagrowingliterature.Thisliteraturehasdevelopedindependentlyofthepropertyrightsliteratureeventhoughtheproblemswithwhichitisconcernedaresimilar;theapproachesareinfacthighlycomplementarytoeachother.Wedefineanagencyrelationshipasacontractunderwhichoneormorepersons(theprincipal(s))engageanotherperson(theagent)toperformsomeserviceontheirbehalfwhichinvolvesdelegatingsomedecisionmakingauthoritytotheagent.Ifbothpartiestotherelationshipareutilitymaximizers,thereisgoodreasontobelievethattheagentwillnotalwaysactinthebestinterestsoftheprincipal.Theprin