INTBUS 6 Lecture Notes - Lecture 15: Agency Cost, Personalization, Substitute Good
6 Oct 2020
School
Department
Course
Professor
Jensen & Meckling: Theory of the Firm: Managerial Behaviour, Agency
Costs and Ownership Structure
1. INTRODUCTION & SUMMARY
MOTIVATION OF THE PAPER
• Purpose of the paper: 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
THEORY OF THE FIRM: AN EMPTY BOX?
• Material subsumed under the heading ‘theory of the firm’ is not a theory of the firm but actually
a theory of markets in which firms are important actors
Firm as a “black box”: operated so as to meet the relevant marginal conditions with respect to inputs
and outputs, thereby maximising profits, or more accurately, present value
• there is no theory which explains how the conflicting objectives of the individual participants are
brought into equilibrium so as to yield this result
• a number of major attempts have been made during recent years to construct a theory of the firm
by substituting other models for profit or value maximization: each attempt motivated by a
conviction that the latter is inadequate to explain managerial behaviour in large corporations
PROPERTY RIGHTS
• specification of individual rights determines how costs and rewards will be allocated among the
participants in any organization
• generally effected through contracting (implicit & explicit) → individual behaviour in organizations
will depend upon the nature of these contracts
AGENCY COSTS
Agency relationship: contract under which one or more persons (principals) engage another person
(agent) to perform some service on their behalf which involves delegating some decision-making
authority to the agent
• if both parties involved are utility maximisers, there is a good reason to believe that the agent will
not always act in the best interests of the principal → principal can limit divergences from his
interest by establishing appropriate incentives for the agent & by incurring monitoring costs
designed to limit the aberrant activities of the agent
• generally, it is impossible for the principal or the agent at zero cost to ensure that the agent will
make optimal decisions from the principal’s viewpoint
Residual loss: dollar equivalent of the reduction in welfare experienced by the principal due to
divergence, a cost of the agency relationship
Agency costs: the sum of (1) monitoring expenditures by the principal, (2) bonding expenditures by
the agent, and (3) the residual loss
• arise in any situation involving cooperative effort by two or more people even though there is no
clear cut principal-agent relationship
• issues associated with the “separation of ownership and control” in the modern diffuse ownership
corporation are intimately associated with the general problem of agency
• paper focus: analysis of agency costs generated by the contractual arrangements between the
owners and top management of the corporation, approach differs fundamentally from most of the
existing literature
→ existing literature: focuses on normative aspects of the agency relationship, that is, how to
structure the contractual relation between the principal and agent to provide appropriate
incentives for the agent to make choices which will maximise the principal’s welfare given that
uncertainty and imperfect monitoring exist
→ focus of the paper on the positive aspects of the theory: assume individuals solve these
normative problems and given that only stocks and bonds can be issued as claims, the authors
investigate the incentives faced by each of the parties and the elements entering into the
determination of the equilibrium contractual form characterizing the relationship between the
manager (agent) of the firm and the outside equity and debt holders (principals)
GENERAL COMMENTS ON THE DEFINITION OF THE FIRM
• Robert Coase characterized the bounds of the firm as that range of exchanges over which the
market system was suppressed and resource allocation was accomplished instead by authority and
direction
• Most organizations are simply legal fictions which serve a nexus for a set of contracting
relationships among individuals → includes firms, non-profit organizations such as universities,
hospitals etc, mutual organizations such as mutual savings banks and insurance companies and co-
operatives
Private corporation or firm: one form of legal fiction which serves a nexus for contracting relationships
among individuals and which is also characterised by the existence of divisible residual claims on the
assets and cash flows of the organization which can generally be sold without permission of the other
contracting individuals
• It makes little or no sense to try to distinguish those things which are “inside” the firm from those
things that are “outside” of it
• Personalization of the firm is misleading
→ the firm is not an individual: it is a legal fiction which serves as a focus for a complex process in
which the conflicting objectives of individuals are brought into equilibrium within a framework of
contractual relations (behaviour of the firm in this sense is like the behaviour of the market
• error: thinking about organizations as if they were persons with motivations and intentions
