Abstract
In this paper we draw on recent progress in the theory of (1) property rights, (2) agency, and (3) finance to develop a theory of ownership structure for the firm.1 In addition to tying together elements of the theory of each of these three areas, our analysis casts new light on and has implications for a variety of issues in the professional and popular literature, such as the definition of the firm, the “separation of ownership and control,” the “social responsibility” of business, the definition of a “corporate objective function,” the determination of an optimal capital structure, the specification of the content of credit agreements, the theory of organizations, and the supply side of the completeness-of-markets problem.
The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.
—Adam Smith, The Wealth of Nations
Reprinted, with some changes, by permission of the authors and North-Holland Publishing Co., from the Journal of Financial Economics 3 (1976): 305–360. An earlier version of the paper was presented at the First Annual Interlaken Seminar on Analysis and Ideology, Switzerland, June 1974.
We are indebted to F. Black, E. Fama, R. Ibbotson, W. Klein, M. Rozeff, R. Weil, O. Williamson, an anonymous referee, and our colleagues and members of the Finance Workshop at the University of Rochester—in particular, G. Benston, M. Canes, D. Henderson, K. Leffler, J. Long, C. Smith, R. Thompson, R. Watts, and J. Zimmerman—for their comments and criticisms.
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Reviews of this literature are given by S. Petersen, “Corporate Control and Capitalism,” Quarterly Journal of Economics 79 (1965): 1–24
A. A. Alchian, “The Basis of Some Recent Advances in the Theory of Management of the Firm,” Journal of Industrial Economics 14 (1965): 30–44
idem, “Corporate Management and Property Rights,” in Economic Policy and the Regulation of Corporate Securities, ed. H. Manne (Washington, D.C.: American Enterprise Institute, 1969)
F. Machlup, “Theories of the Firm: Marginalist, Behavioral, Managerial,” American Economic Review 57 (1967): 1–33
M. Shubik, “A Curmudgeon’s Guide to Microeconomics,” Journal of Economic Literature 8 (1970): 405–434
R. M. Cyert and C. L. Hedrick, “Theory of the Firm: Past, Present and Future,” ibid., 10 (1972): 398-412
B. Branch, “Corporate Objectives and Market Performance,” Financial Management (1973): 24-29
L. E. Preston, “Corporation and Society: The Search for a Paradigm,” Journal of Economic Literature 13 (1975): 434–453.
O. E. Williamson, The Economics of Discretionary Behavior: Managerial Objectives in a Theory of the Firm (Englewood Cliffs, N.J.: Prentice-Hall, 1964); idem, Corporate Control and Business Behavior (Englewood Cliffs, N.J.: Prentice-Hall, 1970); idem, Markets and Hierarchies: Analysis and Antitrust Implications (New York: Free Press, 1975);
R. Marris, The Economic Theory of Managerial Capitalism (Glencoe, Ill.: Free Press, 1964)
W. J. Baumol, Business Behavior, Value and Growth (New York: Macmillan, 1959)
E. Penrose, The Theory of the Growth of the Firm (New York: Wiley, 1958)
R. M. Cyert and J. G. March, A Behavioral Theory of the Firm (Englewood Cliffs, N.J.: Prentice-Hall, 1963). Thorough reviews of these and other contributions are given by F. Machlup, “Theories of the Firm,” and Alchian, “Recent Advances.”.
H. A. Simon, “A Behavioral Model of Rational Choice,” Quarterly Journal of Economics 69 (1955): 99–118, developed a model of human choice incorporating information (search) and computational costs and also having important implications for the behavior of managers. Unfortunately, Simon’s work has often been misinterpreted as a denial of maximizing behavior and has been misused, especially in the marketing and behavioral science literature. His later use of the term satisficing has undoubtedly contributed to this confusion because it suggests rejection of maximizing behavior rather than maximization subject to costs of information and of decision making.
H. A. Simon, “Theories of Decision Making in Economics and Behavioral Science,” American Economic Review 49 (1959):253–283.
R. H. Coase, “The Nature of the Firm,” Economica, n.s. 4 (1937): 386–405, reprinted in Readings in Price Theory, ed. G. J. Stigler and K. Boulding (Homewood, Ill.: Irwin, 1952)
idem, “The Federal Communications Commission,” Journal of Law and Economics 2 (1959): 1-40
idem, “The Problem of Social Costs,” ibid., 3 (1960): 1-44
Alchian, “Recent Advances”; idem, “Corporate Management”
A. A. Alchian and R. A. Kessel, “Competition, Monopoly and the Pursuit of Pecuniary Gain,” in Aspects of Labor Economics, (Princeton, N.J.: Princeton University Press, for the National Bureau of Economic Research, 1962)
H. Demsetz, “Toward a Theory of Property Rights,” American Economic Review 57 (1967): 347–359
A. A. Alchian and H. Demsetz, “Production, Information Costs, and Economic Organization,” ibid. 62 (1972): 777-795
R. J. Monsen and A. Downs, “A Theory of Large Managerial Firms,” Journal of Political Economy 73 (1965): 221–236
M. Silver and R. Auster, “Entrepreneurship, Profit and Limits on Firm Size,” Journal of Business 42 (1969): 277–281
J. C. McManus, “The Costs of Alternative Economic Organizations,” Canadian Journal of Economics 8 (1975): 334–350.
A comprehensive survey of this literature is given by E. G. Furubotn and S. Pejovich, “Property Rights and Economic Theory: A Survey of Recent Literature,” Journal of Economic Literature 10 (1972): 1137–1162.
M. Berhold, “A Theory of Linear Profit-Sharing Incentives,” Quarterly Journal of Economics 85 (1971): 460–482
S. A. Ross, “The Economic Theory of Agency: The Principals Problems,” American Economic Review 63 (1973): 134–139
idem, “The Economic Theory of Agency and the Principle of Similarity,” in Essays on Economic Behavior under Uncertainty, ed. M. D. Balch et al. (Amsterdam: North-Holland, 1974)
R. Wilson, “On the Theory of Syndicates,” Econometrica 36 (1968): 119–132
idem, La decision: Agrégation et dynamique des orders de preference (Paris: Editions du Centre National de la Recherche Scientifique, 1969);
D. G. Heckerman, “Motivating Managers to Make Investment Decisions,” Journal of Financial Economics 2 (1975): 273–292.
A. A. Berle, Jr., and G. C. Means, The Modern Corporation and Private Property (New York: Macmillan, 1932).
R. H. Coase, “Discussion,” American Economic Review 54 (1964): 194–197
H. Demsetz, “Information and Efficiency: Another Viewpoint,” Journal of Law and Economics 12 (1969): 1–22.
H. G. Manne, “Our Two Corporate Systems: Law and Economics,” Virginia Law Review 53 (1967): 259–284; Alchian and Demsetz, “Production.”
F. Modigliani and M. H. Miller, “The Costs of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review 48 (1958): 261–297
idem, “Corporate Income Taxes and the Cost of Capital,” ibid., 53 (1963): 433-443.
A. Kraus and R. Litzenberger, “A State Preference Model of Optimal Financial Leverage,” Journal of Finance 28 (1973): 911–922
P. Lloyd-Davies, “Risk and Optimal Leverage,” unpublished (Rochester, N.Y.: University of Rochester, 1975).
W. F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” Journal of Finance 19 (1964): 425–442; J. Lintner, “Security Prices, Risk, and Maximal Gains from Diversification,” ibid., 20 (1965): 587-616.
F. Black and M. Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy 81 (1973): 637–654.
Smith, “Option Pricing: A Review,” Journal of Financial Economics 3 (1976): 3–52, for a review of the option-pricing literature and its applications; D. Galai and R. W. Masulis, “The Option Pricing Model and the Risk Factor of Stock,” ibid., pp. 53-82, for an application of the model to mergers and corporate investment decisions.
R. C. Merton, “The Theory of Rational Option Pricing,” Bell Journal of Economics and Management Science 4 (1973): 141–183
J. B. Warner, “Bankruptcy Costs, Absolute Priority, and the Pricing of Risky Debt Claims,” unpublished (Chicago: University of Chicago, 1975). Average costs of bankruptcy included only payments to all parties for legal fees, professional services, trustees’ fees, and filing fees. They did not include the costs of management time or changes in cash flows due to shifts in the firm’s demand or cost functions, discussed below.
T. R. Atkinson, Trends in Corporate Bond Quality, Studies in Corporate Bond Finance 4 (New York: National Bureau of Economic Research, 1967).
E. F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance 25 (1970): 383–417.
For an example of this evidence and for references
M.C. Jensen, “Risk, the Pricing of Capital Assets, and the Evaluation of Investment Portfolios,” Journal of Business 42 (1969): 167–247.
M. C. Jensen, “Tests of Capital Market Theory and Implications of the Evidence,” Graduate School of Management Working Paper Series no. 7414 (Rochester, N.Y.: University of Rochester, 1974).
See, among others, K. J. Arrow, “Role of Securities”
A. Diamond, “The Role of a Stock Market in a General Equilibrium Model with Technological Uncertainty,” American Economic Review 57 (1967): 759–776
H. Hakansson, “The Superfund: Efficient Paths toward a Complete Financial Market,” unpublished (University of California, Berkeley, 1974)
idem, “Ordering Markets and the Capital Structures of Firms with Illustrations,” Institute of Business and Economic Research Working Paper no. 24 (Berkeley: University of California, 1974); M. Rubenstein, “A Discrete-Time Synthesis of Financial Theory,” ibid., nos. 20, 21 (1974); S. A. Ross, “Options and Efficiency,” Rodney L. White Center for Financial Research Working Paper no. 3–74 (Philadelphia: University of Pennsylvania, 1974).
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Jensen, M.C., Meckling, W.H. (1979). Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure. In: Brunner, K. (eds) Economics Social Institutions. Rochester Studies in Economics and Policy Issues, vol 1. Springer, Dordrecht. https://doi.org/10.1007/978-94-009-9257-3_8
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