Jensen and Meckling Agency Theory

Jensen and Meckling: "Agency and Firms' Ownership Structure"

Focus is on the relationship between upper-level management and stockholders -- categories which overlap when the owner is the manager.

Although J&M clearly believe that agency problems within the firm explain institutional decisions in other dimensions as well. They expand A&D beyond team production, then focus on a narrower scope.

Main thrust is in explaining ownership structure of the firm as an institution designed to limit agency costs.

Ownership structure: Is financing done through debt or equity markets?

Differences (simplifying):

debt holders get fixed amount, and are generally "first in line" if bankruptcy occurs.

equity holders are residual claimants on assets. Generally more risky, higher return.

We talked before of moral hazard/principal-agent problem/post-contractual opportunism.

In this context, shareholders and managers can have divergent interests.

shareholders: maximize net present value of firm

managers: maximize utilty, of which income is part

Managers may wish to take perquisites (company jets, big offices..)

...or look too much at short term (suboptimal investment decisions)

...or not promote those who threaten them, etc.

Shareholders can imperfectly monitor these decisions.

labor market for managers also places pressure on them to max profits/not overconsumer perqs

however, if all firms and managers face the same moral hazard problem, this problem will persist...

Agency costs=monitoring costs+bonding costs+residual loss

residual loss: loss incurred "by the principal" because the agent's decisions do not serve its interests.

paper not concerned with how principal can motivate agent

assumed that they are able to construct some incentive contract that is optimal given the agency problem that exists.

look at contractual form between managers and share/bondholders in equilibrium.

once again, the firm is not an individual, but a "nexus of contracts"

Agency Costs of...