Agency Cost Jensen Y Meckling

Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure
Michael C. Jensen
Harvard Business School
MJensen@hbs.edu
And
William H. Meckling
University of Rochester
Abstract
This paper integrates elements from the theory of agency, the theory of property rights and the
theory of finance to develop a theory of the ownership structure of the firm. We define the conceptof agency costs, show its relationship to the ‘separation and control’ issue, investigate the nature
of the agency costs generated by the existence of debt and outside equity, demonstrate who bears
costs and why, and investigate the Pareto optimality of their existence. We also provide a new
definition of the firm, and show how our analysis of the factors influencing the creation and
issuanceof debt and equity claims is a special case of 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
theirown. 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.
— Adam Smith (1776)

Keywords: Agency costs and theory, internal control systems,conflicts of interest, capital
structure, internal equity, outside equity, demand for security analysis, completeness of markets,
supply of claims, limited liability
©1976 Jensen and Meckling
Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360.
Reprinted in Michael C. Jensen, A Theory of the Firm: Governance,
Residual Claims and Organizational Forms (Harvard UniversityPress, December 2000)
available at http://hupress.harvard.edu/catalog/JENTHF.html
Also published in Foundations of Organizational Strategy,
Michael C. Jensen, Harvard University Press, 1998.
You may redistribute this document freely, but please do not post the electronic file on the web. I welcome
web links to this document at: http://papers.ssrn.com/abstract=94043. I revise my papersregularly, and
providing a link to the original ensures that readers will receive the most recent version. Thank you,
Michael C. Jensen

Electronic copy available at: http://ssrn.com/abstract=94043

Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure
Michael C. Jensen
Harvard Business School
and
William H. Meckling*
University of Rochester

1. Introduction
1.1.Motivation of the Paper
In this paper we draw on recent progress in the theory of (1) property rights, (2) agency,
and (3) finance to develop a theory of ownership structure1 for the firm. In addition to tying
together elements of the theory of each of these three areas, our analysis casts new light on and
has implications for a variety of issues in the professional and popular literatureincluding 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 problems.

1

W e do not use the term‘capital structure’ because that term usually denotes the relative quantities of
bonds, equity, warrants, trade credit, etc., which represent the liabilities of a firm. Our theory implies there is
another important dimension to this problem—namely the relative amount of ownership claims held by
insiders (management) and outsiders (investors with no direct role in the management of the firm)....