Jensen, M. C., & Meckling, W. H. (1976) Theory of the firm: Managerial behavior, agency costs and ownership structure.

Question 1

GOAL

Answer 1

develop and define the concept of agency and its relationship with the firm

Question 2

The firm is a:

Answer 2

The firm is a “black box” operated so as to meet the relevant marginal conditions with respect to inputs and outputs, thereby maximizing profits, or more accurately, present value.
Input > Black box aka the firm > outputs

Question 3

The firm is not an individual >

Answer 3

it is an network of contractual relationships that brings individuals, often with different objectives and wants, to collaborate on something productive
> In this sense, the “behavior” of the firm is like the behavior of a market; i.e. the outcome of complex equilibrium process

Question 4

assumption of economic rationality

Answer 4

There is a current assumption of economic rationality that everyone will act in best interest of the firm

Question 5

Agency problem:

Answer 5

• When the agents do not act in the best interest of the principal.
• For organisations, ‘the separation of ownership and control’, between that of shareholders (principal) and management (agent), is case-in-point.
• This happens when managers make self-interested decisions that do not align with that of shareholders.

Question 6

Agency relationship

Answer 6

a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.
> If both parties are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal.
> The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent.
> In addition, in some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions.

Question 7

 Agency costs

Answer 7

to the sum of
a) The monitoring expenditures by the principal, (making sure he does okay)
b) The bonding expenditures by the agent, (building trust)
c) The residual loss, costs from the difference between the agent’s decisions and the decisions that would maximize the principal’s welfare