Theory of the Firm - Managerial Behavior, Agency Costs and Ownership Structure

Sep 4, 2026

Uploaded by Kyle

Integrates agency theory, property rights theory, and finance to build a theory of firm ownership structure. Defines agency costs and links them to the “separation and control” issue, analyzing how debt and outside equity create agency costs, who bears them, and why. Examines Pareto optimality of these arrangements, proposes a new definition of the firm, and treats the role of debt and equity claims as a special case of the supply side of the completeness of markets problem.

LanguageEnglish

CategoryResearch & Report

FormatPDF

Pages78

Reading Time3 h 17 min

AccessFree to download

Introduction

Motivation of the Paper

How the theory explains ownership, control, and financing decisions

Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure Michael C. Jensen Harvard Business School 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, itnernal 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 [http://hupress.harvard.edu/catalog/JENTHF.html](http://hupress.harvard.edu/catalog/JENTHF.html) Also published in Foundations of Organizational Strategy, Michael C. Jensen, Harvard University Press, 1998. This document is available on the Social Science Research Network (SSRN) Electronic Library at: [http://papers.ssrn.com/sol3/paper.taf?ABSTRACT_ID=94043](http://papers.ssrn.com/sol3/paper.taf?ABSTRACT_ID=94043) 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) . * Associate Professor and Dean, respectively, Graduate School of Management, University of Rochester. An earlier version of this paper was presented at the Conference on An

FAQs

What theories does the paper integrate to explain ownership structure?

It integrates elements of agency theory, property rights theory, and finance theory to develop a theory of the firm’s ownership structure.

What are agency costs in the paper’s framework?

Agency costs are defined in relation to the separation and control problem, and the paper investigates the agency costs generated by debt and outside equity.

How does the paper connect the firm’s debt and equity arrangements to market completeness?

The analysis of the factors influencing the creation and issuance of debt and equity claims is presented as a special case of the supply side of the completeness of markets problem.

Sep 4, 2026

Uploaded by Kyle

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