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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 concept of agency costs, show its relationship to the Ôseparation and controlÕ 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 issuance of 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 peopleÕs 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 their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their masterÕs 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. Ñ 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 University Press, December 2000) available at 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: papers.ssrn.com/abstract=94043. I revise my papers regularly, and providing a link to the original ensures that readers will receive the most recent version. Thank you, Michael C. Jensen
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