Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure Michael C. Jensen Harvard Business School
[email protected] 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. Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure Michael C. Jensen and William H. Meckling* Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360. 1. Introduction and Summary 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, 1776, Cannan Edition (Modern Library, New York, 1937), p. 700. 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) 1 finance to develop a theory of ownership structure 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 such as the definition of the firm, the "separation of ownership and control," the "social responsibility" of business, the definition of a "corporate objective * 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. 1 We do not use the term