“Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure”, 1979 ():
In this paper, we draw on recent progress in the theory of property rights, agency, and finance to develop a theory of ownership structure for the firm. In addition to tying together elements of the theory of each of these 3 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 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 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.
…Our theory helps explain:
why an entrepreneur or manager in a firm that 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;
why his failure to maximize the value of the firm is perfectly consistent with efficiency;
why the sale of common stock is a viable source of capital even though managers do not literally maximize the value of the firm;
why debt was relied upon as a source of capital before debt financing offered any tax advantage relative to equity;
why preferred stock would be issued;
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;
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;
why some industries are characterized by owner-operated firms whose sole outside source of capital is borrowing;
why highly regulated industries such as public utilities or banks will have higher debt-equity ratios for equivalent levels of risk than the average non-regulated firm;
why security analysis can be socially productive even if it does not increase portfolio returns to investors.
…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 firm have a social responsibility?” is seriously misleading. The firm is not an individual. It is a legal fiction that serves as a focus for a complex process in which the conflicting objectives of individuals (some of whom may “represent” other organizations) are brought into equilibrium within a framework of 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 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.