Theory of the firm jensen
Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure
Michael C. Jensen
Harvard Business School
MJensen@https://www.wendangku.net/doc/6317036844.html,
And
William H. Meckling
University of Rochester
Abstract
This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the ‘separation and control’ issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears
costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of 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 (1776)
Keywords: Agency costs and theory, internal control systems, conflicts of interest, capital structure, internal equity, outside equity, demand for security analysis, completeness of markets, supply of claims, limited liability
?1976 Jensen and Meckling
Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360.
Reprinted in Michael C. Jensen, A Theory of the Firm: Governance,
Residual Claims and Organizational Forms (Harvard University Press, December 2000) available at https://www.wendangku.net/doc/6317036844.html,/catalog/JENTHF.html
Also published in Foundations of Organizational Strategy,
Michael C. Jensen, Harvard University Press, 1998.
You may redistribute this document freely, but please do not post the electronic file on the web. I welcome
web links to this document at: https://www.wendangku.net/doc/6317036844.html,/abstract=94043. I revise my papers regularly, and
providing a link to the original ensures that readers will receive the most recent version. Thank you,
Michael C. Jensen
* Associate Professor and Dean, respectively, Graduate School of Management, University of Rochester. An
earlier version of this paper was presented at the Conference on Analysis and Ideology, Interlaken,
Switzerland, June 1974, sponsored by the Center for Research in Government Policy and Business at the
University of Rochester, Graduate School of Management. We are indebted to F. Black, E. Fama, R.
Ibbotson, W. Klein, M. Rozeff, R. Weil, O. Williamson, an anonymous referee, and to our colleagues and
members of the Finance Workshop at the University of Rochester for their comments and criticisms, in
particular G. Benston, M. Canes, D. Henderson, K. Leffler, J. Long, C. Smith, R. Thompson, R. Watts, and J. Zimmerman.
Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure
Michael C. Jensen
Harvard Business School
and
William H. Meckling*
University of Rochester
1. Introduction
1.1. Motivation of the Paper
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 structure1 for the firm. 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 including 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 problems.
1 We do not use the term ?capital structure‘ because that term usually denotes the relative quantities of
bonds, equity, warrants, trade credit, etc., which represent the liabilities of a firm. Our theory implies there is
another important dimension to this problem—namely the relative amount of ownership claims held by
insiders (management) and outsiders (investors with no direct role in the management of the firm).
Jensen and Meckling 2 1976
Our theory helps explain:
1. why an entrepreneur or manager in a firm which has a mixed financial structure (containing both debt and outside equity claims) will choose a set of activities for the
firm such that the total value of the firm is less than it would be if he were the sole
owner and why this result is independent of whether the firm operates in monopolistic
or competitive product or factor markets;
2. why his failure to maximize the value of the firm is perfectly consistent with efficiency;
3. why the sale of common stock is a viable source of capital even though managers do
not literally maximize the value of the firm;
4. why debt was relied upon as a source of capital before debt financing offered any tax advantage relative to equity;
5. why preferred stock would be issued;
6. why accounting reports would be provided voluntarily to creditors and stockholders,
and why independent auditors would be engaged by management to testify to the
accuracy and correctness of such reports;
7. why lenders often place restrictions on the activities of firms to whom they lend, and
why firms would themselves be led to suggest the imposition of such restrictions;
8. why some industries are characterized by owner-operated firms whose sole outside source of capital is borrowing;
9. why highly regulated industries such as public utilities or banks will have higher debt equity ratios for equivalent levels of risk than the average nonregulated firm;
10. why security analysis can be socially productive even if it does not increase portfolio returns to investors.
Jensen and Meckling 3 1976
1.2 Theory of the Firm: An Empty Box?
While the literature of economics is replete with references to the ―theory of the firm,‖
the material generally subsumed under that heading is not actually a theory of the firm but
rather a
theory of markets in which firms are important actors. The firm is a ―black box‖ operated so as
to meet the relevant marginal conditions with respect to inputs and outputs, thereby maximizing
profits, or more accurately, present value. Except for a few recent and tentative steps, however,
we have no theory which explains how the conflicting objectives of the individual participants are
brought into equilibrium so as to yield this result. The limitations of this black box view of the firm
have been cited by Adam Smith and Alfred Marshall, among others. More recently, popular and
professional debates over the ―social responsibility‖ o f corporations, the separation of ownership
and control, and the rash of reviews of the literature on the ―theory of the firm‖ have evidenced
continuing concern with these issues.2
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, with each attempt motivated
by a conviction that the latter is inadequate to explain managerial behavior in large corporations.3
Some of these reformulation attempts have rejected the fundamental principle of maximizing 2 Reviews of this literature are given by Peterson (1965), Alchian (1965, 1968), Machlup (1967), Shubik (1970),
Cyert and Hedrick (1972), Branch (1973), Preston (1975).
3 See Williamson (1964, 1970, 1975), Marris (1964), Baumol (1959), Penrose (1958), and Cyert and March (1963). Thorough reviews of these and other contributions are given by Machlup (1967) and Alchian (1965).
Simon (1955) developed a model of human choice incorporating information (search) and computational costs which also has important implications for the behavior of managers. Unfortunately, Simon‘s work has often been misinterpreted as a denial of maximizing behavior, and misused, especially in the marketing and behavioral science literatur e. His later use of the term ―satisficing‖ (Simon, 1959) 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.
Jensen and Meckling 4 1976
behavior as well as rejecting the more specific profit-maximizing model. We retain the notion of
maximizing behavior on the part of all individuals in the analysis that follows.4
1.3 Property Rights
An independent stream of research with important implications for the theory of the firm has been stimulated by the pioneering work of Coase, and extended by Alchian, Demsetz, and
others.5 A comprehensive survey of this literature is given by Furubotn and Pejovich (1972). While the focus of this research has been ―property rights‖,6 the subject matter encompassed is
far broader than that term suggests. What is important for the problems addressed here is that specification of individual rights determines how costs and rewards will be allocated among
the
participants in any organization. Since the specification of rights is generally affected through contracting (implicit as well as explicit), individual behavior in organizations, including the behavior
of managers, will depend upon the nature of these contracts. We focus in this paper on the behavioral implications of the property rights specified in the contracts between the owners and
managers of the firm.
1.4 Agency Costs
Many problems associated with the inadequacy of the current theory of the firm can also
be viewed as special cases of the theory of agency relationships in which there is a growing 4 See Meckling (1976) for a discussion of the fundamental importance of the assumption of resourceful, evaluative, maximizing behavior on the part of individuals in the development of theory. Klein (1976) takes an approach similar to the one we embark on in this paper in his review of the theory of the firm and the law.
5 See Coase (1937, 1959, 1960), Alchian (1965, 1968), Alchian and Kessel (1962), Demsetz (1967), Alchian and
Demsetz (1972), Monson and Downs (1965), Silver and Auster (1969), and McManus (1975).
6 Property rights are of course human rights, i.e., rights which are possessed by human beings. The introduction of the wholly false distinction between property rights and human rights in many policy discussions is surely one of the all time great semantic flimflams.
Jensen and Meckling 5 1976
literature.7 This literature has developed independently of the property rights literature even though the problems with which it is concerned are similar; the approaches are in fact highly complementary to each other.
We define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship
are utility maximizers, there is good reason to believe that the agent will not always act in the best
interests of the principal. The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent. In addition in some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the
principal or to ensure that the principal will be compensated if he does take such actions. However, it is generally impossible for the principal or the agent at zero cost to ensure that the
agent will make optimal decisions from the principal‘s viewpoint. In most agency relationships the
principal and the agent will incur positive monitoring and bonding costs (non-pecuniary as well as
pecuniary), and in addition there will be some divergence between the agent‘s decisions8 and those decisions which would maximize the welfare of the principal. The dollar equivalent of the
reduction in welfare experienced by the principal as a result of this divergence is also a cost of the
agency relationship, and we refer to this latter cost as the ―residual loss.‖ We define agency costs as the sum of:
7 Cf. Berhold (1971), Ross (1973, 1974a), Wilson (1968, 1969), and Heckerman (1975).
8 Given the optimal monitoring and bonding activities by the principal and agent.
Jensen and Meckling 6 1976
1. the monitoring expenditures by the principal,9
2. the bonding expenditures by the agent,
3. the residual loss.
Note also that agency costs arise in any situation involving cooperative effort (such as the coauthoring
of this paper) by two or more people even though there is no clear-cut principal-agent relationship. Viewed in this light it is clear that our definition of agency costs and their importance
to the theory of the firm bears a close relationship to the problem of shirking and monitoring of
team production which Alchian and Demsetz (1972) raise in their paper on the theory of the firm.
Since the relationship between the stockholders and the managers of a corporation fits the definition of a pure agency relationship, it should come as no surprise to discover that the issues
associated with the ―separation of ownership and control‖ in the modern diffuse ownership corporation are intimately associated with the general problem of agency. We show below that an
explanation of why and how the agency costs generated by the corporate form are born leads to a
theory of the ownership (or capital) structure of the firm.
Before moving on, however, it is worthwhile to point out the generality of the agency problem. The problem of inducing an ―agent‖ to behave as if he were maximizing the
―principal‘s‖ welfare is quite general. It exists in all organizations and in all cooperative efforts—
at every level of management in firms,10 in universities, in mutual companies, in cooperatives, in
9 As it is used in this paper the term monitoring includes more than just measuring or observing the behavior
of the agent. It includes efforts on the part of the principal to ?control‘ the behavior of the a gent through budget restrictions, compensation policies, operating rules, etc.
10 As we show below the existence of positive monitoring and bonding costs will result in the manager of a corporation possessing control over some resources which he can allocate (within certain constraints) to satisfy his own preferences. However, to the extent that he must obtain the cooperation of others in order
to carry out his tasks (such as divisional vice presidents) and to the extent that he cannot control their behavior perfectly and costlessly they will be able to appropriate some of these resources for their own ends. In short, there are agency costs generated at every level of the organization. Unfortunately, the analysis of these more general organizational is sues is even more difficult than that of the ?ownership and Jensen and Meckling 7 1976
governmental authorities and bureaus, in unions, and in relationships normally classified as agency
relationships such as those common in the performing arts and the market for real estate. The development of theories to explain the form which agency costs take in each of these situations
(where the contractual relations differ significantly), and how and why they are born will lead to a
rich theory of organizations which is now lacking in economics and the social sciences
generally.
We confine our attention in this paper to only a small part of this general problem—the analysis of
agency costs generated by the contractual arrangements between the owners and top management of the corporation.
Our approach to the agency problem here differs fundamentally from most of the existing literature. That literature focuses almost exclusively on the normative aspects of the agency relationship; that is, how to structure the contractual relation (including compensation incentives)
between the principal and agent to provide appropriate incentives for the agent to make choices
which will maximize the principal‘s welfare, given that uncertainty and imperfect monitoring exist.
We focus almost entirely on the positive aspects of the theory. That is, we assume individuals solve these normative problems, and given that only stocks and bonds can be issued as claims, we
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 (i.e., agent) of the firm and the outside equity and debt holders (i.e., principals).
1.5 General Comments on the Definition of the firm
Ro nald Coase in his seminal paper entitled ―The Nature of the Firm‖ (1937) pointed out
that economics had no positive theory to determine the bounds of the firm. He characterized the
control‘ issue because the nature of the contractual obligations and rights of the parties are much more varied and generally not as well specified in explicit contractual arrangements. Nevertheless, they exist and we believe that extensions of our analysis in these directions show promise of producing insights into a viable theory of organization.
Jensen and Meckling 8 1976
bounds of the firm as that range of exchanges over which the market system was suppressed and
where resource allocation was accomplished instead by authority and direction. He focused on
the cost of using markets to effect contracts and exchanges and argued that activities would be
included within the firm whenever the costs of using markets were greater than the costs of using
direct authority. Alchian and Demsetz (1972) object to the notion that activities within the firm are
governed by authority, and correctly emphasize the role of contracts as a vehicle for voluntary
exchange. They emphasize the role of monitoring in situations in which there is joint input or team
production.11 We are sympathetic to with the importance they attach to monitoring, but we believe
the emphasis that Alchian and Demsetz place on joint input production is too narrow and therefore
misleading. Contractual relations are the essence of the firm, not only with employees but with
suppliers, customers, creditors, and so on. The problem of agency costs and monitoring exists
all of these contracts, independent of whether there is joint production in their sense; i.e., joint
production can explain only a small fraction of the behavior of individuals associated with a firm.
It is important to recognize that most organizations are simply legal fictions12 which serve as a nexus for a set of contracting relationships among individuals. This includes firms, non-profit
institutions such as universities, hospitals, and foundations, mutual organizations such as mutual
savings banks and insurance companies and co-operatives, some private clubs, and even governmental bodies such as cities, states, and the federal government, government enterprises
such as TVA, the Post Office, transit systems, and so forth.
11 They define the classical capitalist firm as a contractual organization of inputs in which there is ?(a) joint input production, (b) several input owners, (c) one party who is common to all the contracts of the joint inputs, (d) who has rights to renegotiate any input‘s contract independently of contracts with other input owners, (e) who holds the residual claim, and (f) who has the right to sell his contractual residual status.‘12 By legal fiction we mean the artificial construct under the law which allows certain organizations to be treated as individuals.
Jensen and Meckling 9 1976
The private corporation or firm is simply one form of legal fiction which serves as a nexus for contracting relationships and which is also characterized 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. Although this definition of the firm has little substantive content, emphasizing the essential contractual nature of firms and other organizations
focuses attention on a crucial set of questions—why particular sets of contractual relations arise
for various types of organizations, what the consequences of these contractual relations are, and
how they are affected by changes exogenous to the organization. Viewed this way, it makes little
or no sense to try to distinguish those things that are ―inside‖ the firm (or any other organization)
from those things that are ―outside‖ of it. There is in a very real sense only a multitude of complex relationships (i.e., contracts) between the legal fiction (the firm) and the owners of labor,
material and capital inputs and the consumers of output.13
Viewing the firm as the nexus of a set of contracting relationships among individuals also serves to make it clear that the personalization of the firm implied by asking questions such as
―what should be the objective function of the firm?‖ or ―does the fi rm have a social responsibility?‖ is seriously 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 (some of
whom may ―represent‖ other organizatio ns) are brought into equilibrium within a framework
contractual relations. In this sense the ―behavior‖ of the firm is like the behavior of a market, that
is, the outcome of a complex equilibrium process. We seldom fall into the trap of characterizing
13 For example, we ordinarily think of a product as leaving the firm at the time it is sold, but implicitly or explicitly such sales generally carry with them continuing contracts between the firm and the buyer. If the product does not perform as expected the buyer often can and does have a right to satisfaction. Explicit evidence that such implicit contracts do exist is the practice we occasionally observe of specific provision that ?all sales are final.‘
Jensen and Meckling 10 1976
the wheat or stock market as an individual, but we often make this error by thinking about organizations as if they were persons with motivations and intentions.14
1.6 Overview of the Paper
We develop our theory in stages. Sections 2 and 4 provide analyses of the agency costs
of equity and debt respectively. These form the major foundation of the theory. In Section 3, we
pose some questions regarding the existence of the corporate form of organization and examines
the role of limited liability. Section 5 provides a synthesis of the basic concepts derived in sections
2-4 into a theory of the corporate ownership structure which takes account of the trade-offs available to the entrepreneur-manager between inside and outside equity and debt. Some qualifications and extensions of the analysis are discussed in section 6, and section 7 contains a
brief summary and conclusions.
2. The Agency Costs of Outside Equity
2.1 Overview
In this section we analyze the effect of outside equity on agency costs by comparing the behavior of a manager when he owns 100 percent of the residual claims on a firm with his behavior when he sells off a portion of those claims to outsiders. If a wholly-owned firm is managed by the owner, he will make operating decisions that maximize his utility. These decisions
14 This view of the firm points up the important role which the legal system and the law play in social organizations, especially, the organization of economic activity. Statutory laws sets bounds on the kinds of contracts into which individuals and organizations may enter without risking criminal prosecution. The police powers of the state are available and used to enforce performance of contracts or to enforce the collection of damages for non-performance. The courts adjudicate conflicts between contracting parties and establish precedents which form the body of common law. All of these government activities affect both the
kinds of contracts executed and the extent to which contracting is relied upon. This in turn determines the usefulness, productivity, profitability and viability of various forms of organization. Moreover, new laws as well as court decisions often can and do change the rights of contracting parties ex post, and they can and do serve as a vehicle for redistribution of wealth. An analysis of some of the implications of these facts is contained in Jensen and Meckling (1978) and we shall not pursue them here.
Jensen and Meckling 11 1976
will involve not only the benefits he derives from pecuniary returns but also the utility generated by
various non-pecuniary aspects of his entrepreneurial activities such as the physical appointments
of the office, the attractiveness of the office staff, the level of employee discipline, the kind
amount of charitable contributions, personal relati ons (―friendship,‖ ―respect,‖ and so on) with
employees, a larger than optimal computer to play with, or purchase of production inputs from
friends. The optimum mix (in the absence of taxes) of the various pecuniary and non-pecuniary
benefits is achieved when the marginal utility derived from an additional dollar of expenditure
(measured net of any productive effects) is equal for each non-pecuniary item and equal to the
marginal utility derived from an additional dollar of after-tax purchasing power (wealth).
If the owner-manager sells equity claims on the corporation which are identical to his own (i.e., which share proportionately in the profits of the firm and have limited liability), agency costs
will be generated by the divergence between his interest and those of the outside shareholders, since he will then bear only a fraction of the costs of any non-pecuniary benefits he takes out in
maximizing his own utility. If the manager owns only 95 percent of the stock, he will expend resources to the point wh ere the marginal utility derived from a dollar‘s expenditure of the firm‘s
resources on such items equals the marginal utility of an additional 95 cents in general purchasing
power (i.e., his share of the wealth reduction) and not one dollar. Such activities, on his part, can
be limited (but probably not eliminated) by the expenditure of resources on monitoring activities by
the outside stockholders. But as we show below, the owner will bear the entire wealth effects of
these expected costs so long as the equity market anticipates these effects. Prospective minority
shareholders will realize that the owner-manager‘s interests will diverge somewhat from theirs;
hence the price which they will pay for shares will reflect the monitoring costs and the effect of
the divergence between the manager‘s interest and theirs. Nevertheless, ignoring for the moment
the possibility of borrowing against his wealth, the owner will find it desirable to bear these costs
Jensen and Meckling 12 1976
as long as the welfare increment he experiences from converting his claims on the firm into general purchasing power15 is large enough to offset them.
As the owner-manager‘s fraction of the equity falls, his fractional claim on the outcomes
falls and this will tend to encourage him to appropriate larger amounts of the corporate resources
in the form of perquisites. This also makes it desirable for the minority shareholders to expend
more resources in monitoring his behavior. Thus, the wealth costs to the owner of obtaining additional cash in the equity markets rise as his fractional ownership falls.
We shall continue to characterize the agency conflict between the owner-manager and outside shareholders as deriving from the manager‘s tendency to appropriate perquisites out of the
f irm‘s resources for his own consumption. However, we do not mean to leave the impression that
this is the only or even the most important source of conflict. Indeed, it is likely that the most important conflict arises from the fact that as the manager‘s o wnership claim falls, his incentive to
devote significant effort to creative activities such as searching out new profitable ventures falls.
He may in fact avoid such ventures simply because it requires too much trouble or effort on his
part to manage or to learn about new technologies. Avoidance of these personal costs and the anxieties that go with them also represent a source of on-the-job utility to him and it can result in
the value of the firm being substantially lower than it otherwise could be.
2.2 A Simple Formal Analysis of the Sources of Agency Costs of Equity and Who Bears Them
In order to develop some structure for the analysis to follow we make two sets of assumptions. The first set (permanent assumptions) are those which will carry through almost all
of the analysis in sections 2-5. The effects of relaxing some of these are discussed in section 6.
15 For use in consumption, for the diversification of his wealth, or more importantly, for the financing of
?profitable‘ projects which he could not otherwise finance out of his personal wealth. We deal with these issues below after having developed some of the elementary analytical tools necessary to their solution. Jensen and Meckling 13 1976
The second set (temporary assumptions) are made only for expositional purposes and are relaxed
as soon as the basic points have been clarified.
Permanent assumptions
(P.1) All taxes are zero.
(P.2) No trade credit is available.
(P.3) All outside equity shares are non-voting.
(P.4) No complex financial claims such as convertible bonds or preferred stock or
warrants can be issued.
(P.5) No outside owner gains utility from ownership in a firm in any way other than through its effect on his wealth or cash flows.
(P.6) All dynamic aspects of the multiperiod nature of the problem are ignored by assuming there is only one production-financing decision to be made by the entrepreneur.
(P.7) The entrepreneur-manager‘s money wages are held constant throughout the analysis.
(P.8) There exists a single manager (the peak coordinator) with ownership interest in
the firm.
Temporary assumptions
(T.1) The size of the firm is fixed.
(T.2) No monitoring or bonding activities are possible.
(T.3) No debt financing through bonds, preferred stock, or personal borrowing (secured
or unsecured) is possible.
Jensen and Meckling 14 1976
(T.4) All elements of the owner-manager‘s decision problem involving portfolio considerations induced by the presence of uncertainty and the existence of
diversifiable risk are ignored.
Define:
X = {x1, x2, . . .,x n} = vector of quantities of all factors and activities within the
firm from which the manager derives non-pecuniary benefits;16 the x i are defined
such that his marginal utility is positive for each of them;
C(X) = total dollar cost of providing any given amount of these items;
P(X) = total dollar value to the firm of the productive benefits of X;
B(X) = P(X)-C(X) = net dollar benefit to the firm of X ignoring any effects of X on
the equilibrium wage of the manager.
Ignoring the effects of X on the manager‘s utility and therefore on his equilibrium wage rate, the optimum levels of the factors and activities X are defined by X* such
that
?B(X*)
?X *
=
?P(X*)
?X *
-
?C(X*)
?X *
= 0.
Thus for any vector X ≥ X* (i.e., where at least one element of X is greater than its corresponding element of X*), F ≡ B(X*) - B(X) > 0 measures the dollar cost to the firm (net of
any productive effects) of providing the increment X - X* of the factors and activities which generate utility to the manager. We assume henceforth that for any given level of cost to the firm,
F, the vector of factors and activities on which F is spent on those, X? , which yield the manager
maximum utility. Thus F ≡ B(X*) - B( X? ).
16 Such as office space, air conditioning, thickness of the carpets, friendliness of employee relations, etc. Jensen and Meckling 15 1976
We have thus far ignored in our discussion the fact that these expenditures on X occur through time and therefore there are trade-offs to be made across time as well as between alternative elements of X. Furthermore, we have ignored the fact that the future expenditures are
likely to involve uncertainty (i.e., they are subject to probability distributions) and therefore some
allowance must be made for their riskiness. We resolve both of these issues by defining C, P, B,
and F to be the current market values of the sequence of probability distributions on the periodby-
period cash flows involved.17
Given the definition of F as the current market value of the stream of manager‘s expenditures on non-pecuniary benefits, we represent the constraint which a single
ownermanager
faces in deciding how much non-pecuniary income he will extract from the firm by the
line V F in fig. 1. This is analogous to a budget constraint. The market value of the firm is measured along the vertical axis and the market value of the manager‘s stream of expenditures on
non-pecuniary benefits, F, is measured along the horizontal axis. OV is the value of the firm when the amount of non-pecuniary income consumed is zero. By definition V is the maximum
market value of the cash flows generated by the firm for a given money wage for the manager
when the manager‘s consumption of non-pecuniary benefits are zero. At this point all the factors
and activities within the firm which generate utility for the manager are at the level X* defined
above. There is a different budget constraint V F for each possible scale of the firm (i.e., level of
investment, I) and for alternative levels of money wage, W, for the manager. For the moment we
pick an arbitrary level of investment (which we assume has already been made) and hold the scale of the firm constant at this level. We also assume that the manager‘s money wage is fixed
17 And again we assume that for any given market value of these costs, F, to the firm the allocation across time and across alternative probability distributions is such that the manager‘s current expected utility is at a
maximum.
Jensen and Meckling 16 1976
at the level W* which represents the current market value of his wage contract18 in the optimal
compensation package which consists of both wages, W*, and non-pecuniary benefits, F*. Since
one dollar of current value of non-pecuniary benefits withdrawn from the firm by the manager
reduces the market value of the firm by $1, by definition, the slope of V F is -1.
The owner-manager‘s tastes for wealth and non-pecuniary benefits is represented in fig.
1 by a system of indifference curves, U1, U2, and so on.19 The indifference curves will be convex
as drawn as long as the owner-manager‘s marginal rate of substitution between non-pecuniary
benefits and wealth diminishes with increasing levels of the benefits. For the 100 percent ownermanager,
this presumes that there are not perfect substitutes for these benefits available on the outside, that is, to some extent they are job-specific. For the fractional owner-manager this presumes that the benefits cannot be turned into general purchasing power at a constant price.20
When the owner has 100 percent of the equity, the value of the firm will be V* where indifference curve U2 is tangent to VF, and the level of non-pecuniary benefits consumed is F*.
If the owner sells the entire equity but remains as manager, and if the equity buyer can, at zero
18 At this stage when we are considering a 100% owner-managed firm the notion of a ?wage contract‘ with himself has no content. However, the 100% owner-managed case is only an expositional device used in passing to illustrate a number of points in the analysis, and we ask the reader to bear with us briefly while we lay out the structure for the more interesting partial ownership case where such a contract does have substance.
19 The manager‘s utility function is actually defined over wealth and the future time sequence of vectors of quantities of non-pecuniary benefits, X t. Although the setting of his problem is somewhat different, Fama (1970b, 1972) analyzes the conditions under which these preferences can be represented as a derived utility function defined as a function of the money value of the expenditures (in our notation F) on these goods conditional on the prices of goods. Such a utility function incorporates the optimization going on in the background which define X? discussed above for a given F. In the more general case where we allow a time series of consumption, X? t, the optimization is being carried out across both time and the components of X t for fixed F.
20 This excludes, for instance, (a) the case where the manager is allowed to expend corporate resources on anything he pleases in which case F would be a perfect substitute for wealth, or (b) the case where he can
?steal‘ cash (or other marketable assets) with constant returns to scale—if he could the indifference curves would be straight lines with slope determined by the fence commission.
Jensen and Meckling 17 1976
cost, force the old owner (as manager) to take the same level of non-pecuniary benefits as he did
as owner, then V* is the price the new owner will be willing to pay for the entire equity.21 Fig. 1. The value of the firm (V) and the level of non-pecuniary benefits consumed (F) when the fraction
of outside equity is (1-α)V, and U j(j = 1,2,3) represents owner‘s indifference curves between wealth an d non-pecuniary benefits.
21 Point D defines the fringe benefits in the optimal pay package since the value to the manager of the fringe benefits F* is greater than the cost of providing them as is evidenced by the fact that U2 is steeper to the
left of D than the budget constraint with slope equal to -1.
That D is indeed the optimal pay package can easily be seen in this situation since if the conditions of the sale to a new owner specified that the manager would receive no fringe benefits after the sale he would require a payment equal to V3 to compensate him for the sacrifice of his claims to V* and fringe benefits amounting to F* (the latter with total value to him of V3-V*). But if F = 0, the value of the firm is only V . Therefore, if monitoring costs were zero the sale would take place at V* with provision for a pay package which included fringe benefits of F* for the manager.
This discussion seems to indicate there are two values for the ?firm‘, V3 and V*. This is not the case if we realize that V* is the value of the right to be the residual claimant on the cash flows of the firm and V3-V* is the value of the managerial rights, i.e., the right to make the operating decisions which include access to F*. There is at least one other right which has value which plays no formal role in the analysis as yet—the value
of the control right. By control right we mean the right to hire and fire the manager and we leave this issue to a future paper.
Jensen and Meckling 18 1976
In general, however, we could not expect the new owner to be able to enforce identical behavior on the old owner at zero costs. If the old owner sells a fraction of the firm to an outsider, he, as manager, will no longer bear the full cost of any non-pecuniary benefits he consumes. Suppose the owner sells a share of the firm, 1-α, (0 < α < 1) and retains for himself a
share, a. If the prospective buyer believes that the owner-manager will consume the same level
of non-pecuniary benefits as he did as full owner, the buyer will be willing to pay (1-α)V* for a
fraction (1-α) of the equity. Given that an outsider now holds a claim to (1-α) of the equity, however, the cost to the owner-manager of consuming $1 of non-pecuniary benefits in the firm
will no longer be $1. Instead, it will be α x $1. If the prospective buyer actually paid (1-α)V* for
his share of the equity, and if thereafter the manager could choose whatever level of nonpecuniary
benefits he liked, his budget constraint would be V1P1 in fig. 1 and has a slope equal to - α, Including the payment the owner receives from the buyer as part of the owner‘s post-sale wealth, his budget constraint, V1P1, must pass through D, since he can if he wishes have the same
wealth and level of non-pecuniary consumption he enjoyed as full owner.
But if the owner-manager is free to choose the level of perquisites, F, subject only to the loss in wealth he incurs as a part owner, his welfare will be maximized by increasing his consumption of non-pecuniary benefits. He will move to point A where V1P1 is tangent to U1 representing a higher level of utility. The value of the firm falls from V*, to V0, that is, by the amount of the cost to the firm of the increased non-pecuniary expenditures, and the
own ermanager‘s
consumption of non-pecuniary benefits rises from F* to F0.
If the equity market is characterized by rational expectations the buyers will be aware that the owner will increase his non-pecuniary consumption when his ownership share is reduced. If
the owner‘s response function is known or if the equity market makes unbiased estimates of the
Jensen and Meckling 19 1976
owner‘s response to the changed incentives, the buyer will not pay (1-α)V* for (1-α) of the equity.
Theorem. For a claim on the firm of (1-a) the outsider will pay only (1-a) times the
value he expects the firm to have given the induced change in the behavior of the owner-manager.
Proof. For simplicity we ignore any element of uncertainty introduced by the lack of perfect knowledge of the owner-manager‘s response function. Such uncertainty will not affect
the final solution if the equity market is large as long as the estimates are rational (i.e., unbiased)
and the errors are independent across firms. The latter condition assures that this risk is diversifiable and therefore that equilibrium prices will equal the expected values.
Let W represent the owner‘s total wealth after he has sold a claim equal to 1-α of the
equity to an outsider. W has two components. One is the payment, S o, made by the outsider for
1-α of the equity; the rest, S i, is the value of the owner‘s (i.e., insider‘s) share of the firm, so that
W, the owner‘s wealth, is given by
W = S o + S i = S o + αV(F, α),
where V(F, α) represents the value of the firm given that the ma nager‘s fractional ownership share is α and that he consumes perquisites with current market value of F. Let
V2P2,
with a slope of -α represent the trade-off the owner-manager faces between non-pecuniary benefits and his wealth after the sale. Given that the owner has decided to sell a claim 1-α of the
firm, his welfare will be maximized when V2P2 is tangent to some indifference curve such as
fig. 1. A price for a claim of (1-α) on the firm that is satisfactory to both the buyer and the seller
will require that this tangency occur along V F , that is, that the value of the firm must be V?. To
show this, assume that such is not the case—that the tangency occurs to the left of the point B on
the line V F . Then, since the slope of V2P2 is negative, the value of the firm will be larger than V‘.
Jensen and Meckling 20 1976
The owner-manager‘s choice of this lower level of consumption of non-pecuniary benefits will
imply a higher value both to the firm as a whole and to the fraction of the firm (1-α) which the
outsider has acquired; that is, (1-α)V? > S o. From the owner‘s viewpoint, he has sold 1-α of the
firm for less than he could have, given the (assumed) lower level of non-pecuniary benefits he
enjoys. On the other hand, if the tangency point B is to the right of the line V F , the ownermanager‘s
higher consumption of non-pecuniary benefits means the value of the firm is less than
V?, and hence (1-α)V(F, α) < S o = (1-α)V?. The outside owner then has paid more for his share
of the equity than it is worth. S o will be a mutually satisfactory price if and only if (1-α)V? = S o.
But this means that the owner‘s post-sale wealth is equal to the (reduced) value of the firm V?, since
W = S o + a V? = (1-α)V? + a V? = V?.
Q.E.D.
The requirement that V? and F? fall on V F is thus equivalent to requiring that the value of
the claim acquired by the outside buyer be equal to the amount he pays for it, and conversely for
the owner. This means that the decline in the total value of the firm (V*-V?) is entirely imposed on the owner-manager. His total wealth after the sale of (1-α) of the equity is V? and the decline in his wealth is V*-V?.
The distance V*-V? is the reduction in the market value of the firm engendered by the agency relationship and is a measure of the ―residual loss‖ defined earlier. In this simple example
the residual loss represents the total agency costs engendered by the sale of outside equity because monitoring and bonding activities have not been allowed. The welfare loss the owner incurs is less than the residual loss by the value to him of the increase in non-pecuniary benefits
(F?-F*). In fig. 1 the difference between the intercepts on the Y axis of the two indifference Jensen and Meckling 21 1976
curves U2 and U3 is a measure of the owner-manager‘s welf are loss due to the incurrence of agency costs,22 and he would sell such a claim only if the increment in welfare he achieved by using the cash amounting to (1-α)V? for other things was worth more to him than this amount of
2.3 Determination of the Optimal Scale of the Firm
The case of all equity financing. Consider the problem faced by an entrepreneur with
initial pecuniary wealth, W, and monopoly access to a project requiring investment outlay, I, subject
to diminishing returns to scale in I. Fig. 2 portrays the solution to the optimal scale of the firm
taking into account the agency costs associated with the existence of outside equity. The axes are
as defined in fig. 1 except we now plot on the vertical axis the total wealth of the owner, that is,
his initial wealth, W, plus V(I)-I, the net increment in wealth he obtains from exploitation of his
investment opportunities. The market value of the firm, V = V(I,F), is now a function of the level
of investment, I, and the current market value of the m anager‘s expenditures of the firm‘s resources on non-pecuniary benefits, F. Let V (I) represent the value of the firm as a function of
the level of investment when the manager‘s expenditures on non-pecuniary benefits, F, are zero.
The schedule with intercept labeled W + [V (I *)- I*)] and slope equal to -1 in fig. 2 represents the
locus of combinations of post-investment wealth and dollar cost to thefirm of non-pecuniary benefits which are available to the manager when investment is carried to the value maximizing
point, I*. At this point ?V (I ) - ?I = 0 . If the manager‘s wealth were large enough to cover the investment required to reach this scale of operation, I*, he would consume F* in non-pecuniary
22 The distance V*-V? is a measure of what we will define as the gross agency costs. The distance V3-V4 is a measure of what we call net agency costs, and it is this measure of agency costs which will be minimized by
the manager in the general case where we allow investment to change.
Jensen and Meckling 22 1976
benefits and have pecuniary wealth with value W + V*-I*. However, if outside financing is required to cover the investment he will not reach this point if monitoring costs are non-zero.23
The expansion path OZBC represents the equilibrium combinations of wealth and nonpecuniary
benefits, F, which the manager could obtain if he had enough personal wealth to finance
all levels of investment up to I*. It is the locus of points such as Z and C which present the equilibrium position for the 100 percent owner-manager at each possible level of investment, I. As
I increases we move up the expansion path to the point C where V(I)-I is at a maximum. Additional investment beyond this point reduces the net value of the firm, and as it does the equilibrium path of the manager‘s wealth and non-pecuniary benefits retraces (in the reverse direction) the curve OZBC. We draw the path as a smooth concave function only as a matter of
convenience.
Fig. 2. Determination of the optimal scale of the firm in the case where no monitoring takes place. Point C
denotes optimum investment, I*, and non-pecuniary benefits, F*, when investment is 100% financed by entrepreneur. Point D denotes optimum investment, I?, and non-pecuniary benefits, F, when outside equity financing is used to help finance the investment and the entrepreneur owns a fraction α? of the firm. The distance A measures the gross agency costs.
23 I* is the value maximizing and Pareto Optimum investment level which results from the traditional analysis
of the corporate investment decision if the firm operates in perfectly competitive capital and product markets
and the agency cost problems discussed here are ignored. See Debreu (1959, ch. 7), Jensen and Long (1972), Long (1972), Merton and Subrahmanyam (1974), Hirshleifer (1958, 1970), and Fama and Miller (1972).
Jensen and Meckling 23 1976
If the manager obtained outside financing and if there were zero costs to the agency relationship (perhaps because monitoring costs were zero), the expansion path would also be represented by OZBC. Therefore, this path represents what we might call the ―idealized‖solutions, that is, those which would occur in the absence of agency costs.
Assume the manager has sufficient personal wealth to completely finance the firm only up
to investment level I1, which puts him at point Z. At this point W = I1. To increase the size of the
firm beyond this point he must obtain outside financing to cover the additional investment required,
and this means reducing his fractional ownership. When he does this he incurs agency costs, and
the lower his ownership fraction, the larger are the agency costs he incurs. However, if the investments requiring outside financing are sufficiently profitable his welfare will continue to increase.
The expansion path ZEDHL in fig. 2 portrays one possible path of the equilibrium levels of the owner‘s non-pecuniary benefits and wealth at each possible level of investment higher than I1.
This path is the locus of points such as E or D where (1) the ma nager‘s indifference curve is tangent to a line with slope equal to -α (his fractional claim on the firm at that level of investment),
and (2) the tangency occurs on the ―budget constraint‖ with slope = -1 for the firm value and nonpecuniary
benefit trade-off at the same level of investment.24 As we move along ZEDHL his
24 Each equilibrium point such as that at E is characterized by (a? , F? ,
c
Wt ) where
c
Wt is the entrepreneur‘s
post-investment financing wealth. Such an equilibrium must satisfy each of the following four conditions: (1)
c
Wt + F = V (I) + W - I = V (I) - K,
where K ≡ I-W is the amount of outside financing required to make the investment I. If this condition is not satisfied there is an uncompensated wealth transfer (in one direction or the other) between the entrepreneur and outside equity buyers.
(2) UF(
c
Wt ,F? )/ UWt (
c
Wt ,F? ) = a?,
where U is the entrepreneur‘s utility function on wealth and perquisites, UF and UWt are marginal utilities
and a? is the manager‘s share of the firm.
Jensen and Meckling 24 1976
fractional claim on the firm continues to fall as he raises larger amounts of outside capital. This
expansion path represents his complete opportunity set for combinations of wealth and nonpecuniary
benefits, given the existence of the costs of the agency relationship with the outside
equity holders. Point D, where this opportunity set is tangent to an indifference curve, represents
the solution which maximizes his welfare. At this point, the level of investments is I?, his fractional
ownership share in the firm is a…, his wealth is W+V?-I?, and he consumes a stream of nonpecuniary
benefits with current market value of F?. The gross agency costs (denoted by A) are
equal to (V*-I*)-(V?-I?). Given that no monitoring is possible, I? is the socially optimal level of
investment as well as the privately optimal level.
We can characterize the optimal level of investment as that point, I? which satisfies the following condition for small changes:
_V - _I + α?_F = 0 (1)
_V-_I is the change in the net market value of the firm, and a…_F is the dollar value to
the manager of the incremental fringe benefits he consumes (which cost the firm _F dollars).25
Furthermore, recognizing that V = V - F, where V is the value of the firm at any level of investment when F = 0, we can substitute into the optimum condition to get
(3) (1 -a?)V(I) = (1 - a? )[V (I) - F? ] ≥ K,
which says the funds received from outsiders are at least equal to K, the minimum required outside financing.
(4) Among all points (a? , F? ,
c
Wt ) satisfying conditions (1)-(3), (a, F,Wt) gives the manager highest utility.
This implies that (a? , F? ,
c
Wt ) satisfy condition (3) as an equality.
25 Proof. Note that the slope of the expansion path (or locus of equilibrium points) at any point is (_V-
_I)/_F and at the optimum level of investment this must be equal to the slope of the manager‘s indifference curve between wealth and market value of fringe benefits, F. Furthermore, in the absence of monitoring, the
slope of the indifference curve, _W?_F, at the equilibrium point, D, must be equal to -α?. Thus,
(_V-_I)/_F = -α? (2)
Jensen and Meckling 25 1976
(?V - ?I) - 1-a' )?F = 0 (3)
as an alternative expression for determining the optimum level of investment.
The idealized or zero agency cost solution, I*, is given by the condition (?V - ?I) = 0 ,
and since _F is positive the actual welfare maximizing level of investment I? will be less than I*,
because (?V - ?I) must be positive at I? if (3) is to be satisfied. Since -α? is the slope of the indifference curve at the optimum and therefore represents the manager‘s demand price for incremental non-pecuniary benefits, _F, we know that α?_F is the dollar value to him of an increment of fringe benefits costing the firm _F dollars. The term (1-α?)_F thus measures the
dollar ―loss‖ to the firm (and himself) of an additional _F dollars spent on non-pecuniary benefits.
The term ?V - ?I is the gross increment in the value of the firm ignoring any changes in the consumption of non-pecuniary benefits. Thus, the manager stops increasing the size of the firm
when the gross increment in value is just offset by the incremental ―loss‖ involved in the consumption of additional fringe benefits due to his declining fractional interest in the firm.26 is the condition for the optimal scale of investment and this implies condition (1) holds for small changes at the optimum level of investment, I?.
26 Since the manager‘s indifference curves are negatively sloped we know that the optimum scale of the firm,
point D, will occur in the region where the expansion path has negative slope, i.e., the market value of the firm, will be declining and the gross agency costs, A, will be increasing and thus, the manager will not minimize them in making the investment decision (even though he will minimize them for any given level of
investment). However, we define the net agency cost as the dollar equivalent of the welfare loss the manager experiences because of the agency relationship evaluated at F = 0 (the vertical distance between the intercepts on the Y axis of the two indifference curves on which points C and D lie). The optimum solution, I?, does satisfy the condition that net agency costs are minimized. But this simply amounts to a restatement of the assumption that the manager maximizes his welfare.
Finally, it is possible for the solution point D to be a corner solution and in this case the value of the firm will not be decli ning. Such a corner solution can occur, for instance, if the manager‘s marginal rate of substitution between F and wealth falls to zero fast enough as we move up the expansion path, or if the investment projects are ―sufficiently‖ profitable. In these case s the expansion path will have a corner which lies on the maximum value budget constraint with intercept V (I*) - I * , and the level of investment will be equal to the idealized optimum, I*. However, the market value of the residual claims will be less than V* because the manager‘s consumption of perquisites will be larger than F*, the zero agency cost level. Jensen and Meckling 26 1976
2.4 The Role of Monitoring and Bonding Activities in Reducing Agency Costs
In the above analysis we have ignored the potential for controlling the behavior of the owner-manager through monitoring and other control activities. In practice, it is usually possible
by expending resources to alter the opportunity the owner-manager has for capturing nonpecuniary
benefits. These methods include auditing, formal control systems, budget restrictions,
the establishment of incentive compensation systems which serve to identify the manager‘s interests more closely with those of the outside equity holders, and so forth. Fig. 3 portrays the
effects of monitoring and other control activities in the simple situation portrayed in fig. 1. Figs. 1
and 3 are identical except for the curve BCE in fig. 3 which depicts a ―budget constraint‖ derived
when monitoring possibilities are taken into account. Without monitoring, and with outside equity
of (1-α), the value of the firm will be V? and non-pecuniary expenditures F?. By incurring monitoring costs, M, the equity holders can restrict the manager‘s consumption of perquisites to
amounts less than F‘. Let F(M, α) denote the maximum perquisites the manager can consume for alternative levels of monitoring expenditures, M, given his ownership share α. We assume that increases in monitoring reduce F, and reduce it at a decreasing rate, that is, ?F/?M < 0 and
?2F/?M2 > 0.
Since the current value of expected future monitoring expenditures by the outside equity holders reduce the value of any given claim on the firm to them dollar for dollar, the outside equity
holders will take this into account in determining the maximum price they will pay for any given
fraction of the firm‘s equity. Therefore, given positive monitoring activity the value of the firm is
given by V = V - F(M,a) - M and the locus of these points for various levels of M and for a given level of α lie on the line BCE in fig. 3. The vertical difference between the V F and BCE
curves is M, the current market value of the future monitoring expenditures.
Jensen and Meckling 27 1976
If it is possible for the outside equity holders to make these monitoring expenditures and thereby to impose the reductions in the owner-manager‘s consumption of F, he will voluntarily
enter into a contract with the outside equity holders which gives them the rights to restrict his consumption of non-pecuniary items to F”. He finds this desirable because it will cause the value
of the firm to rise to V” Given the contract, the optimal monitoring expenditure on the part of the
outsiders, M, is the amount D-C. The entire increase in the value of the firm that accrues will be
reflected in the owner‘s wealth, but his welfare will be increased by less than this because he forgoes some non-pecuniary benefits he previously enjoyed.
Fig. 3. The value of the firm (V) and level of non-pecuniary benefits (F) when outside equity is (1-α), U1, U2, U3 represent owner‘s indifference curves between wealth and non-pecuniary benefits, and monitoring (or bonding) activities impose opportunity set BCE as the tradeoff constraint facing the owner.
Jensen and Meckling 28 1976
If the equity market is competitive and makes unbiased estimates of the effects of monitoring expenditures on F and V, potential buyers will be indifferent between the following two
contracts:
Purchase of a share (1-α) of the firm at a total price of (1-α)V? and no rights to monitor
or control the manager‘s consumption of perquisites.
Purchase of a share (1-α) of the firm at a total price of (1-α)V” and the right to expend resources up to an amount equal to D-C which will limit the owner-manager‘s consumption of
perquisites to F”.
Given the contract (ii) the outside shareholders would find it desirable to monitor to the full rights of their contract because it will pay them to do so. However, if the equity market is competitive the total benefits (net of the monitoring costs) will be capitalized into the price of the
claims. Thus, not surprisingly, the owner-manager reaps all the benefits of the opportunity to write
and sell the monitoring contract.27
An analysis of bonding expenditures. We can also see from the analysis of fig. 3 that
it makes no difference who actually makes the monitoring expenditures—the owner bears the full