Theory of the Firm

Berle and Means (1932) initially argued that in modern corporations there exists separation between control and ownership. As a result, a manager run the corporation to maximize his/her private benefits which often deviate from interests of owners to maximize value of the firm, or profits. After 44 years Jensen and Meckling (1976) formulated “Theory of the Firm” as a formal model of Berle and Means’s ideas using standard tools of classical economics. The deviation, which is so-called agency problems, can be solved by allowing the manager having share of the firm. The larger manager ownership is the lower the agency costs due to private benefits of the manager are partly derived from profits. Another way to solve agency problems is higher ownership concentration such that the owner has ability to exercise his/her power to monitor or even to fire the managers. Then, Jensen and Meckling predict that relationship between ownership concentration and profit is positive.

As a note, the high concentration ownership produces another agency problem that is conflict of interests between large shareholders and minority shareholders.

The seminal paper of Jensen and Meckling can be downloaded for free here.