A Theory of the Firm: Governance, Residual Claims, and Organizational Forms

Rating:
Summary: The elegant theory of the firm
Review: Elegant and well elaborated, Jensen presents the classic economic theory of the firm. The one shortcoming is that the activities of the firm in an international and social context are not touched on. I recommend this book with another that elaborates on the theory of the firm in social and political environments, such as Usha Haley's "Multinational Corporations in Political Environments".

Rating:
Summary: The seminal works of agency cost economics collected
Review: Michael Jensen is one of the founders of the agency cost economics branch of the New Institutional Economics. "A Theory of the Firm" collects eight articles by Jensen and various co-authors that, collectively, represent the seminal body of work in this field. (I wonder how his various co-authors felt about being left of the spine of this book?) While his contributions to agency cost theory are the work for which he is best known, Jensen also figures prominently in the intellectual history of the nexus of contracts theory of the firm, as several of the articles collected here demonstrate.

U.S. public corporations are characterized by a separation of ownership and control: the firm's nominal owners, the shareholders, exercise virtually no control over either day to day operations or long-term policy. Instead, control is vested in the hands of professional managers, who typically own only a small portion of the firm's shares. The separation of ownership and control characteristic of U.S. corporations has costs: "The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge . . . ." (Berle and Means, 1932). Modern scholars refer to the consequences of these divergences as agency costs, following Jensen and Meckling (1976), which are conventionally defined as the sum of the monitoring and bonding costs, plus any residual loss, incurred to prevent shirking by agents. In turn, shirking is conventionally defined to include as any action by a member of a production team that diverges from the interests of the team as a whole. As such, shirking includes not only culpable cheating, but also negligence, oversight, incapacity, and even honest mistakes. In other words, shirking is simply the inevitable consequence of bounded rationality and opportunism within agency relationships. The classic Jensen & Meckling article is reprinted herein.

Although agency cost theory undeniably is critical to understanding the modern corporate form, too many agency cost theorists have narrowly focused on agency costs to the exclusion of other institutional considerations, which easily can distort one's understanding. Corporate managers operate within a pervasive web of accountability mechanisms that substitute for monitoring by residual claimants. Important constraints are provided by a variety of market forces. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by firm agents. In addition, the legal system evolved various adaptive responses to the ineffectiveness of shareholder monitoring, establishing alternative accountability structures to punish and deter wrongdoing by firm agents, such as the board of directors. An even more important consideration, however, is that agency costs are the inevitable consequence of vesting discretion in someone other than the residual claimant. We could substantially reduce, if not eliminate, agency costs by eliminating discretion; that we do not do so suggests that discretion has substantial virtues. A complete theory of the firm thus requires one to balance the virtues of discretion against the need to require that discretion be used responsibly. Neither discretion nor accountability can be ignored, because both promote values essential to the survival of business organizations. Unfortunately, they are ultimately antithetical: one cannot have more of one without also having less of the other - the power to hold to account is the power to decide. Managers cannot be made more accountable without undermining their discretionary authority. Establishing the proper mix of discretion and accountability thus emerges as the central corporate governance question.

Jensen recognizes this tension in several of the articles collected here, which in general are less lex-centric than those of many of his intellectual progeny. In other words, Jensen is less likely to believe that regulation is an appropriate solution to a given problem. Instead, his work focuses on market solutions to agency cost problems. The articles on takeovers and leveraged buyouts are good examples.

Given the many virtues of Jensen's work, why have I subtracted one star? Mostly because there is nothing new here. To be sure, it is useful to have all Jensen's major agency cost articles collected in a convenient forum. And this text can remind a new generation of scholars of Jensen's early work. Yet, newcomers and generalists may find the text heavy going in places, while us old-timers have already read all of these articles in their original publications.

Rating:
Summary: The seminal works of agency cost economics collected
Review: Michael Jensen is one of the founders of the agency cost economics branch of the New Institutional Economics. "A Theory of the Firm" collects eight articles by Jensen and various co-authors that, collectively, represent the seminal body of work in this field. (I wonder how his various co-authors felt about being left of the spine of this book?) While his contributions to agency cost theory are the work for which he is best known, Jensen also figures prominently in the intellectual history of the nexus of contracts theory of the firm, as several of the articles collected here demonstrate.

U.S. public corporations are characterized by a separation of ownership and control: the firm's nominal owners, the shareholders, exercise virtually no control over either day to day operations or long-term policy. Instead, control is vested in the hands of professional managers, who typically own only a small portion of the firm's shares. The separation of ownership and control characteristic of U.S. corporations has costs: "The separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge . . . ." (Berle and Means, 1932). Modern scholars refer to the consequences of these divergences as agency costs, following Jensen and Meckling (1976), which are conventionally defined as the sum of the monitoring and bonding costs, plus any residual loss, incurred to prevent shirking by agents. In turn, shirking is conventionally defined to include as any action by a member of a production team that diverges from the interests of the team as a whole. As such, shirking includes not only culpable cheating, but also negligence, oversight, incapacity, and even honest mistakes. In other words, shirking is simply the inevitable consequence of bounded rationality and opportunism within agency relationships. The classic Jensen & Meckling article is reprinted herein.

Although agency cost theory undeniably is critical to understanding the modern corporate form, too many agency cost theorists have narrowly focused on agency costs to the exclusion of other institutional considerations, which easily can distort one's understanding. Corporate managers operate within a pervasive web of accountability mechanisms that substitute for monitoring by residual claimants. Important constraints are provided by a variety of market forces. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by firm agents. In addition, the legal system evolved various adaptive responses to the ineffectiveness of shareholder monitoring, establishing alternative accountability structures to punish and deter wrongdoing by firm agents, such as the board of directors. An even more important consideration, however, is that agency costs are the inevitable consequence of vesting discretion in someone other than the residual claimant. We could substantially reduce, if not eliminate, agency costs by eliminating discretion; that we do not do so suggests that discretion has substantial virtues. A complete theory of the firm thus requires one to balance the virtues of discretion against the need to require that discretion be used responsibly. Neither discretion nor accountability can be ignored, because both promote values essential to the survival of business organizations. Unfortunately, they are ultimately antithetical: one cannot have more of one without also having less of the other - the power to hold to account is the power to decide. Managers cannot be made more accountable without undermining their discretionary authority. Establishing the proper mix of discretion and accountability thus emerges as the central corporate governance question.

Jensen recognizes this tension in several of the articles collected here, which in general are less lex-centric than those of many of his intellectual progeny. In other words, Jensen is less likely to believe that regulation is an appropriate solution to a given problem. Instead, his work focuses on market solutions to agency cost problems. The articles on takeovers and leveraged buyouts are good examples.

Given the many virtues of Jensen's work, why have I subtracted one star? Mostly because there is nothing new here. To be sure, it is useful to have all Jensen's major agency cost articles collected in a convenient forum. And this text can remind a new generation of scholars of Jensen's early work. Yet, newcomers and generalists may find the text heavy going in places, while us old-timers have already read all of these articles in their original publications.

Rating:
Summary: A Modern Theory of the Firm?
Review: This book is a collection of eight previously published papers by Prof. Michael Jensen (and co-authors) of the Harvard Business School in a stream of research dealing with agency theoretic formulations of the theory of the firm.

It is aimed specifically at research scholars in financial economics, strategic management, organizational theory, and public policy. Because it is a collection, the papers tend to vary in style and technicality from impassioned advocacy (chapter 3) to general narrative (chapter 2) to formal mathematical modeling (chapter 6). Deliberately little was done to reedit the papers for flow and while this tends to give the reader mental whiplash as he tries to adjust between chapters, it maintains the integrity of the original thoughts that went into the original papers. It makes a good first book for Ph.D. students and scholars new to the field needing a quick summary of a half-century of theoretical development; and because only they would have the tenacity to plow through the formal models.

The ideas in the book are not new to scholars familiar to the field, but they do represent the theoretical cutting edge, which attests to the robustness of Prof. Jensen's ideas (chapter four was first published in 1976) or to the more cynical - a lack of theoretical advancement. Because they are brought together in one place, the book neatly presents the historical development and theoretical arguments in a way that sorting through a bunch of papers cannot.

The main point the book makes is that one cannot build a complete theory of the firm, typically encountered in traditional production models, without special consideration for the governance mechanisms that ensure the efficient deployment of resources and distribution of wealth. For example, the book demonstrates the theoretical and practical importance of knowing the identity of the firm's owner. In classical theories of the firm, owners are merely suppliers of capital, homogenously risk averse and value maximizing. The book however makes an oft-missed point in today's heady arguments over shareholder wealth maximization and corporate responsibility that all parties to the contract called The Firm have different risk preferences. For example, institutional owners may even have conflicting risk preferences, which can result in control issues such as minority oppression that do not arise in classical theory-of-the-firm formulations.

The book early on dismisses the usefulness of traditional conceptions of the firm as pure production functions. Instead, it reconstructs a theory of the firm on a positive agency theory foundation, arguing that it is the contractual relationship between the suppliers and users of capital and talent that determine what, how and when production occurs. This framework brings together the following elements: a. The importance of capital structure, i.e., debt/equity mix and types, refuting Modigliani and Miller's (1958) irrelevance hypothesis, b. The importance of governance structure, making Jensen one of the earliest to emphasize the important role of outside directors in the boardroom, c. The role of transaction specific and specialized knowledge, elevating the theoretical significance of the knowledge worker, d. The importance of the residual claimant, centralizing the shareholder, and e. The existence and nature of agency costs, which Jensen notes are inevitable between parties with asymmetric information and different preference curves.

This theoretical model is elegantly simple and yet powerful enough to deal with such diverse organizational structures as the owner-operated firm to the widely held multi-unit public corporation. It is particularly suited to theoretical modeling such topics as top management compensation, self-governing contracts, mutual monitoring at the firm and individual levels of analyses, distribution of residuals, hierarchy, and corporate takeovers.

The book also makes a credible attempt to apply agency theory, without direct reference to sociological constructs, to different organizational forms such as mutuals, partnerships, labor-managed, cooperatives, owner operated, substantially controlled, and the widely held public corporation. Chapter six is particularly interesting in this regard because it attempts to applying the theoretical framework to labor managed organizations, most commonly seen in Communist political economies. The original paper's conclusion that such systems are doomed to failure presages the collapse of the Soviet state and the ensuing adjustments toward free market systems around the world.