Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure

The authors argue that what economics calls the “theory of the firm” is “not a theory of the firm but actually a theory of markets in which firms are important actors” – the firm itself is treated as a “black box” that simply meets marginal conditions with respect to inputs and outputs to maximize profit or present value, with no account of how “the conflicting objectives of the individual participants are brought into equilibrium.” Their alternative, following and extending Coase, is that “most organizations are simply legal fictions which serve as a nexus for a set of contracting relationships among individuals” – a firm “is not an individual” but “a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals…are brought into equilibrium within a framework of contractual relations,” so that asking “what should be the objective function of the firm” or “does the firm have a social responsibility” is, in their words, “seriously misleading.”

An agency relationship is “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”; because both parties are assumed to be utility maximizers, “there is good reason to believe that the agent will not always act in the best interests of the principal.” Agency costs are defined as the sum of three things: the principal’s monitoring expenditures, the agent’s bonding expenditures (resources the agent spends to credibly guarantee he won’t take certain harmful actions), and the “residual loss” – the dollar-equivalent welfare reduction to the principal from whatever divergence between agent behavior and principal-maximizing behavior remains even after optimal monitoring and bonding. The authors stress this problem “exists in all organizations and in all cooperative efforts – at every level of management in firms, in universities, in mutual companies, in cooperatives, in governmental authorities and bureaus, in unions,” not only in the stockholder-manager relationship, though the paper confines its formal analysis to that relationship.

With non-pecuniary benefits X (office amenities, staff, charitable giving, etc.) costing the firm F in market value, a 100-percent owner-manager consumes the level F that equates his marginal utility of a dollar of such benefits to his marginal utility of a dollar of wealth, the efficient point where firm value is maximized at V*.* If he instead sells a fraction (1-α) of the equity and retains α, “the cost to the owner-manager of consuming $1 of non-pecuniary benefits in the firm will no longer be $1. Instead, it will be α × $1” – so if a prospective buyer naively paid (1-α)V* expecting the manager’s behavior to be unchanged, the manager’s welfare-maximizing response is to raise his perk consumption above F* (moving to a flatter indifference-curve tangency), which pushes firm value down from V* toward a lower value, call it V′.

The paper’s “Theorem” states that for a claim on the firm of (1-α), a rational outside buyer will pay only (1-α) times the value he expects the firm to have given the induced change in the owner-manager’s behavior – not (1-α) times the pre-sale value V*. Proving this formally, the authors show the owner-manager’s total post-sale wealth, W = S₀ + αV(F,α), reduces exactly to V′ (the reduced firm value anticipated given his new incentives) regardless of the split between the sale proceeds S₀ and his retained equity stake; “the decline in the total value of the firm (V* − V′) is entirely imposed on the owner-manager. His total wealth decline after the sale of (1-α) of the equity is V* − V′,” and this distance is precisely the “residual loss” defined in Section 1 – a result the authors highlight because it refutes the casual intuition that selling shares to naive outsiders is a way for a manager to “exploit” them: a rational market prices the exploitation in advance, so the manager who creates the incentive to shirk is the one who ultimately pays for it.

Using an option-pricing framework (Black-Scholes), the authors model equity in a levered firm as a call option on the firm’s total value with exercise price equal to the face value of the debt; because the value of a call option rises with the variance of the underlying asset, equity holders who have already sold bonds have an incentive to switch from a lower-variance to a higher-variance investment even when the higher-variance project has a lower total expected value, because doing so transfers value from existing bondholders to themselves. If bondholders are “naive” (fail to anticipate this switch), this redistributes wealth from bondholders to the manager with no net welfare loss; but “it is easy to construct a case…in which these incentive effects do generate real costs,” since rational bondholders who correctly anticipate the lower-value project will being chosen will only pay a lower price B₂ < B₁ for the bonds up front, and the firm then actually proceeds with the lower-total-value project – a real, not merely redistributive, destruction of value that is part of the agency cost of debt.

The authors identify three components of the agency costs of debt: the incentive effects associated with highly leveraged financial structures (as in Q5), the monitoring costs these incentive effects induce creditors to incur (and the resulting costs, such as covenant restrictions, that creditors impose on the firm), and bankruptcy and reorganization costs. They motivate the puzzle sharply: “we don’t find many large firms financed almost entirely with debt type claims…because of the effect such a financial structure would have on the owner-manager’s behavior. Potential creditors will not loan $100,000,000 to a firm in which the entrepreneur has an investment of $10,000” – since with such leverage the owner-manager would have a strong incentive to take very high-risk, high-payoff gambles, capturing the upside while creditors absorb most of the downside.

Holding the firm’s scale and the total amount of external financing fixed, the authors define A_S(E) as the agency costs arising from outside equity (increasing in E, the fraction of outside financing obtained as equity, since more outside equity means the manager retains a smaller claim and so has a stronger incentive to shirk) and A_B(E) as the agency costs arising from debt (decreasing in E, since more debt means less outside equity and, for a given firm, a larger share of any value reallocated from debtholders accrues to an increasingly small managerial equity stake, so the incentive to expropriate falls as E rises). Total agency costs are A_T(E) = A_S(E) + A_B(E), and the paper’s proposed theory of optimal capital structure is that the firm settles at the E* minimizing A_T(E) – “not…at the intersection of A_S(E) and A_B(E), but at the point where the absolute value of the slopes of the functions are equal.” The authors explicitly flag this as an open empirical question regarding the exact curvature of these cost functions, saying “we are far from understanding the full details…but confess as our own” that pinning down the second derivatives will take substantial further theoretical and empirical work.

Taken literally, the paper’s equity model implies an owner-manager who resorts to any outside funding should keep 100 percent of his own wealth invested in his firm, since doing so avoids the agency costs additional outside funding imposes – “an implication which is not consistent with what we generally observe,” since most owner-managers hold a relatively small fraction of their wealth in the firm they manage. The authors resolve this by introducing portfolio diversification: because asset returns are not perfectly correlated, an owner with all his wealth in a single firm “will generally bear a welfare loss (if he is risk averse) because he is bearing more risk than necessary,” so he is willing to pay something (in the form of the agency costs from a lower ownership fraction) to diversify into other assets – meaning “the manager’s desire to avoid risk will contribute to his becoming a minority stockholder” even though shareholders and bondholders price this diversification-driven dilution into what they pay.

The introduction lists ten things the theory purports to explain, including why a manager with mixed debt and outside equity financing chooses activities that leave total firm value below what it would be under sole ownership, yet why this failure to maximize value “is perfectly consistent with efficiency”; why the sale of common stock remains a viable source of capital despite this; why debt was used as a financing source even before it had any tax advantage; why lenders impose restrictions on borrowing firms (and firms themselves may suggest such restrictions); why some industries feature owner-operated firms whose only outside capital is debt; why heavily regulated industries such as utilities and banks carry higher debt-equity ratios than unregulated firms of similar risk; and why voluntary accounting disclosure and independent auditing arise even without a legal mandate to provide them. The thread connecting all ten is that each is a market- or contract-level response that reduces the total agency costs identified in the paper’s formal models, rather than an anomaly relative to a value-maximization benchmark.

The authors close by calling the publicly held business corporation “an awesome social invention”: “millions of individuals voluntarily entrust billions of dollars, francs, pesos, etc., of personal wealth to the care of managers on the basis of a complex set of contracting relationships,” and the historical growth in both the number of corporations and the market value of corporate equity suggests that “at least up to the present, creditors and investors have by and large not been disappointed with the results, despite the agency costs inherent in the corporate form.” They attribute the corporation’s survival to an evolutionary, competitive process among organizational forms – “whatever the current list of imperfections, the organizational structure existing in each industry represents, at any point in time, the survivors of a selection process” that favors forms minimizing agency costs given available contracting technology, statutory law, and human ingenuity, while stressing that agency costs “are as real as any other costs.”