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):

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 utility, of which income is part

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

Shareholders can imperfectly monitor these decisions.

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 Equity

Non-profit maximization even sole owners may not profit maximize

...but this is efficient because they are maximizing utility and bear all of the costs of their decisions. If the sole owner wants a fancy computer, no problem...

If a manager is the enterprise's only residual claimant, than there is no efficiency loss from perquisite-taking. One can interpret it as on-the-job consumption. The manager bears the full cost of any on the job consumption which decreases the pecuniary returns he receives from the enterprise.

Efficiency losses -- agency costs -- arise when managers do not bear the full consequences of their decisions.

Suppose now they are not the sole owner

This is the nature of agency costs from outside equity.

Who bears these costs? The agent!

Why? In selling equity shares, prospective buyers will realize the agency problem makes the shares worth less, and will pay less for them. They will take into account the firm's value given the new ownership structure.

So it is in the agent's interest to devise a contract that limits the agency costs of equity.

Agency problem gets larger, the smaller the percentage of the firm that is owned by the manager...or, the greater amount that equity financing is relied upon.

Agency explanation also applies to managers' incentive to forego potentially profitable opportunities which require effort.

Agency costs vary with:

Why are there owners other than the manager? Investments exceed manager's personal wealth.

Having non-manager-owned shares introduces agency costs.

Agency costs of debt

Debt: fixed payments, possibility of default in cases of bankruptcy.

What incentives does borrowing introduce? Excessive risk-taking.

Insulates manager from the full impact of decisions -- limits losses in bad states of the world.


Project A Investment Good Bad

$750 $1750 $750 E(profit)=$1250

debtholders $262.5 $262.5

stockholders $1487.5 $487.5 E(profit)=$987.5

Project B Investment Good Bad

$750 $2400 $0 E(profit)=$1200

debtholders $262.5 $0

stockholders $2137.5 $0 E(profit)=$1068.5

Manager chooses riskier project with lower expected value -- increase probability of default

monitoring and bonding can be used to reduce total agency costs

w/debt, in addition there may be costs associated w/bankruptcy: legal fees, reorganization, etc.

agency cost of debt = monitoring+bonding+bankruptcy + residual losses

who bears these costs, if capital markets are perfect? manager/owner.

Equilibrium Ownership Structure

Fraction of outside financing from debt and equity. Given amount of outside financing, minimize total agency costs (see notes).