Jensen and Meckling 1976 Summary

Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure
By: Michael Jenson and William Meckling

Introduction and Summary
1. Motivation
a. Draw on property rights, agency and finance to develop ownership structure theory
2. Theory of the Firm: An Empty Box
a. Meet inputs and outputs to maximize profits
3. Property Rights
a. Means “human rights” in this paper
b. Affected by contracts
i. Behavior of managers effected
4. Agency Costs
a. Sum of
i. Monitoring expenditures by the principal ii. Bonding expenditures by the agent iii. Residual loss
b. Includes principal – agent relationship and cooperative effort
c. Most literature focuses on how to structure contracts between principal and agent to minimize agency costs (maximize principals welfare)
5. Some General Comments on the Definition of the Firm
a. Legal fictions which serve as a nexus for a set of contracting relationships among individuals
i. 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

The Agency Cost of Outside Equity
1. Overview
a. Compare behavior of manager who owns 100% vs. less than 100%
i. Wholly owned he makes operating decisions which maximize his utility
1. Pecuniary returns and non-pecuniary aspects ii. Manager will expend resources to the point where the marginal utility derived from a dollar’s expenditure equals the marginal utility of additional purchasing power iii. As percent ownership falls, increased monitoring costs
2. Simple Formal Analysis of the Sources of Agency Costs of Equity and Who Bears Them
a. Permanent Assumptions on page 314
b. Temporary assumptions on page 314
c. Figure 1
i. The value of the firm and the level of non-pecuniary benefits consumed when the fraction of outside equity is (1-a)V and utility curves representing owner’s indifference curves between wealth and non-pecuniary benefits
d. 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
i. The decline on the value of the firm is entirely imposed on the owner-manager
3. Determination of the Optimal Scale of the Firm
a. Figure 2
i. Determination of the optimal scale of the firm in the case where no monitoring takes place
4. The Role of Monitoring and Bonding Activities in Reducing Agency Costs
a. Equity holders have ways to reduce managers consumption of perquisites
i. Will do this as long as the current value of the monitoring costs is less than the NPV of the savings ii. Managers wealth may increase but will lose some benefits iii. Can lead to an optimal size of the firm
b. Figure 3
i. The value of the firm and level of non-pecuniary benefits when outside equity is (1-a), and U represents owner’s indifference curves between wealth and non-pecuniary benefits and monitoring activities impose opportunity set BCE as the tradeoff constraint facing the owner
5. Pareto Optimality and Agency Costs in Manager-Operated Firms
a. Agency costs are non-zero
b. Agency relationship is a non-optimal and wasteful organization structure
6. Factors Affecting the Size of the Divergence from Ideal Maximization
a. Magnitude of agency costs will vary from firm to firm
i. Tastes of managers ii. Ease at which managers can exercise preferences iii. Costs of monitoring and bonding activities iv. Cost of measuring managers performance
v. Cost of devising and applying compensation metrics vi. Cost of behavior rules or policies
b. Constrained by the market for the firm itself
i. Owners can always sell their firm
c. Competition as a limit on managerial misbehavior?
i. Monopoly will permit larger divergences from value maximization is frequently argued
1. Owners will still undertake costs to minimize agency problems

Some Unanswered Questions Regarding the Existence of the Corporate Form
1. The Question
a. Why are millions of people willing to become residual claimants?
i. Many other ways to raise capital
1. Bonds
2. Notes
3. Mortgages
b. Many argue that managers do not behave in the interest of stockholders
i. Why have non-manager-owed shares not been driven out by fixed claims?
2. Some Alternative Explanations of the Ownership Structure of the Firm
a. Limited liability is one of the most important features of equity claims
i. It just shifts risk ii. If shareholders had unlimited liability, it would be spread over many shareholders
1. Shareholders would then have incentive to keep track of both liabilities of GM and wealth of other shareholders
2. Pay creditors a higher interest rate to contract limited liability to shareholders
b. The irrelevance of capital structure
i. MM (58) demonstrated that in the absence of bankruptcy costs and tax subsidies on interest, firm value is independent of the financial structure
1. MM (63) demonstrate that tax subsidies would increase the value of the firm ii. Debt was issued prior to the current tax subsidies iii. Tax subsidies and bankruptcy costs cannot explain preferred stock and warrants