Michael Jensen and William Meckling’s famous 1976 Journal of Financial Economics article has been cited nearly 100,000 times and is often regarded as a fierce critique of the public company. That is a misinterpretation: Jensen and Meckling were fans, not critics.
Editor’s note: The current debate in economics seems to lack a historical perspective. To try to address this deficiency, we decided to launch a Sunday column on ProMarket focusing on the historical dimension of economic ideas. You can read all of the pieces in the series here.
French philosopher and sociologist Bruno Latour wrote in 1987 that “a paper may be cited by others … to support a claim which is exactly the opposite of what its author intended.”
Michael Jensen and William Meckling’s famous 1976 Journal of Financial Economics article “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” exemplifies the pattern. Ostensibly, Jensen and Meckling were fierce critics of the public company who put forward an ambitious governance reform wish list. The record on this should be set straight Jensen would subsequently become a high-profile detractor of the publicly traded corporation. “Theory of the Firm” offered, however, an optimistic take on the public company and had little to say about changing the corporate landscape.
“Theory of the Firm” has been cited nearly 100,000 times. It came to prominence in part because of Jensen and Meckling’s characterization of the firm as a nexus for contracting relationships. While incorporated entities are vested formally with legal personality, Jensen and Meckling treated the corporate form as “a mere legal fiction” of minimal analytical significance. They said theorizing about corporations should occur with “the essential contractual nature of firms” as the departure point.
“Theory of the Firm” is even better known for its contribution to agency theory. Jensen and Meckling, by putting agency costs at the center of their 56-page analysis of the ownership structure of firms, laid the groundwork for a wide-ranging research agenda that would have a profound intellectual impact in the realms of economics, corporate governance, corporate law and organizational behavior. Their departure point was assuming that where one party, the principal, engages another, the agent, to perform a service on behalf of the principal, there will necessarily be agency costs because the agent will not always make choices that maximize the welfare of the principal.
With agency costs being “an unavoidable result of the agency relationship,” Jensen and Meckling reasoned that a public company with hired managers inevitably would not be “run in a manner so as to maximize its value.” A commonly held view is that a forceful agency-cost driven indictment of public companies ensued from this insight. According to sociologists Frank Dobbin and Jiwook Jung, “Theory of the Firm” treated the interests of executives and shareholders as “out of sync.” Management professor Gerald Davis says Jensen and Meckling combined their “ideas into a comprehensive critique” that implied it “didn’t make sense” for investors to “put their savings into shares of companies.” Law professor Lynn Stout elaborated:
“Jensen and Meckling saw the passivity of dispersed shareholders in public corporations as a serious weakness that invited professional managers to neglect shareholders’ interests in the pursuit of their own, leading managers to shirk or even steal from the firm. The result was the dread ‘agency costs’ whose lurking presence in public corporations has haunted many finance economists and corporate governance experts ever since.”
Jensen and Meckling, the thinking goes, not only diagnosed the public company’s substantial ailments but also pressed for governance adjustments as a cure. “Theory of the Firm” supposedly called for independent and engaged boards to step forward to oversee and discipline senior executives. In addition, Jensen and Meckling ostensibly recommended executive pay reform, advocating linking compensation closely to shareholder returns. They also reputedly argued that the threat of displacement by a hostile takeover bid could and should be for public company executives a potent source of managerial discipline.
Jensen and Meckling in fact did not lobby for any sort of full-scale rewiring of the public company in “Theory of the Firm.” There was no call, for instance, to fortify public company boards with independent directors. Instead, Jensen and Meckling ignored directors, lumping them together with executives under the label “managers”. On the executive pay front, Jensen and Meckling acknowledged that “incentive compensation systems for the manager” could be deployed to address concerns “large publicly held corporations seem to behave in a risk averse way to the detriment of the equity holders” but did not press the case for reform of existing arrangements. As for takeovers, Jensen and Meckling acknowledged that in public companies there were occasional “conflicts for control” but did not use the term “takeover” once and said “(f)urther analysis of these issues is left to the future.”
Why did Jensen and Meckling refrain from condemning the public company and from proposing changes? The reason is simple: they were fans, not critics. Their verdict was that “(t)he publicly held business corporation is an awesome social invention.” Jensen and Meckling acknowledged “there were alternative organizational forms available, and opportunities to invent new ones.” Nevertheless, they noted, “(m)illions of individuals voluntarily entrust billions of dollars, francs, pesos, etc., of personal wealth to the care of managers” of publicly traded companies. Given Jensen and Meckling’s favorable assessment of the public company, neither harsh criticism nor robust prescriptions for improvement were likely to follow.
Jensen and Meckling, being aware of the inevitability of agency costs, asked rhetorically “(h)ow does it happen that millions of individuals are willing to turn over a significant fraction of their wealth to organizations run by managers who have so little interest in their welfare?” Their answer: “the law and the sophistication of contracts relevant to the modern corporation are the products of a historical process in which there were strong incentives for individuals to minimize agency costs.” Jensen and Meckling’s analysis of the precise mechanisms involved was cursory. While they acknowledged that executive pay and “conflicts for control” could be relevant, they focused primarily on the stock market. They assumed that high agency costs would depress share prices, which would disadvantage proprietors of firms as well as outside investors. Those in charge correspondingly had a market-driven incentive to reduce agency costs.
Jensen and Meckling’s market-oriented optimism regarding the public company’s place in the business world is not surprising given their theoretical priors. As colleagues at the University of Rochester’s business school they shared a deep faith in market outcomes, having both studied at the University of Chicago in the 1950s and 1960s. Indeed, Jensen and Meckling said in another paper written in the mid-1970s it was “reasonable to argue that all markets are always in equilibrium, and all forces must always be in balance at all times.”
When Jensen and Meckling’s faith in market forces was combined with their characterization of the public company as a nexus of contracting relations, an optimistic verdict regarding the public company logically followed. With a firm being a nexus of contracts, no obvious demarcation exists between the bargains struck in a market environment and intra-firm arrangements. Correspondingly, for Jensen and Meckling public companies, as with conventional markets, were presumptively in a state of value-enhancing equilibrium.
Michael Jensen’s subsequent academic endeavors contributed substantially to the disconnect between what “Theory of the Firm” supposedly said and actually said about the public company. Jensen went from being a 1970s fan of the public company to a vocal 1990s skeptic, who maintained America’s corporate governance arrangements were deeply flawed. Subsequent commentators have understandably sought to draw connections between the views Jensen advanced subsequently and the 1970s work with Meckling. While the emphasis on continuity with regard to Jensen’s work on the public company is explicable, this has been a misstep. His take on the public company in fact underwent a 180-degree turn subsequent to the publication of “Theory of the Firm”. Jensen and Meckling’s academic classic is destined to be misunderstood unless this key point is borne in mind.
This post is based on “What Jensen and Meckling Really Said About the Public Company,” a working paper to be published as a chapter by Edward Elgar in Elizabeth Pollman and Robert Thompson (eds.), Research Handbook on Corporate Purpose and Personhood.