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 ‘separation and control’ 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.

This paper analyzes the survival of organizations in which decision agents do not bear a major share of the wealth effects of their decisions. This is what the literature on large corporations calls separation of “ownership” and “control.” Such separation of decision and risk bearing functions is also common to organizations like large professional partnerships, financial mutuals and nonprofits. We contend that separation of decision and risk bearing functions survives in these organizations in part because of the benefits of specialization of management and risk bearing but also because of an effective common approach to controlling the implied agency problems. In particular, the contract structures of all these organizations separate the ratification and monitoring of decisions from the initiation and implementation of the decisions.

Fiscal policy is procyclical in many developing countries. We explain this policy failure with a political agency problem. Procyclicality is driven by voters who seek to ”starve the Leviathan ” to reduce political rents. Voters observe the state of the economy but not the rents appropriated by corrupt We thank Jordi Gali and three anonymous referees for excellent comments. We are also

The foundations are being put in place for a revolution in the science of organizations. Some major analytical building blocks for the development of a theory of organizations are outlined and discussed in this paper. This development of organization theory will be hastened by increased understanding of the importance of the choice of definitions, tautologies, analytical techniques, and types of evidence. The two literatures of agency theory are briefly discussed in light of these issues. Because accounting is an integral part of the structure of every organization, the development of a theory of organizations will be closely associated with the development of a theory of accounting. This theory will explain why organizations take the form they do, why they behave as they do, and why accounting practices take the form they do. Because such positive theories as these are required for purposeful decision making, their development will provide a better scientific basis for the decisions of managers, standard-setting boards, and government regulatory bodies.

Abstract not found

We explain the empirical puzzle why mergers reduce profits and raise share prices. If it is better to be an “insider ” than an “outsider, ” firms may merge to preempt their partner merging with a rival. The stock-value of the insiders is increased, since the risk of becoming an outsider is eliminated. We also explain why shareholders of targets gain while acquirers typically break even. These results are derived in an endogenous-merger model, predicting the conditions under which mergers occur, when they occur, and how the surplus is shared.

A Dynamic Theory of Organizational Choice A central proposition in organization theory is that discrete organizational forms are matched to environmental conditions, market strategies, or exchange conditions. This paper develops a contrary theoretical proposition. We argue that efficiency may dictate modulating between discrete governance modes (i.e., structural modulation) in response to a stable set of exchange conditions. If governance choices are discrete as much of organization theory argues, then the consequent steady-state functionality delivered by these organizational forms is itself discrete. However, if the desired functionality lies in between the steady-state functionality delivered by two discrete choices, then efficiency gains may be available by modulating between modes. We develop an analytical model of structural modulation and examine factors that influence when modulation is efficiency enhancing as well as the optimal rate of modulation. We conclude that, under certain conditions, structural modulation is efficiency enhancing. Further, contrary to theories that highlight the potentially destructive consequences of inertia on

We analyze the design and renegotiation of covenants in debt contracts as a specific example of the contractual assignment of property rights under asymmetric information. In particular, we consider a setting where managers are better informed than the lenders regarding potential transfers from debt to equity that are associated with future investments. We show that this simple adverse-selection problem leads to the allocation of greater ex-ante decision rights to the creditor (the uninformed party) – i.e., tighter covenants – than would follow under symmetric information. This corresponds well with empirical evidence indicating covenants are indeed very tight upon inception. Strict covenants in turn lead to a bias in ex-post renegotiation, with the creditor giving up these excessive rights – i.e., covenants are waived. This result contrasts with the conclusion of standard incomplete contracting models of ex-ante hold-up, where the party with the more important ex-ante investments – presumably management, rather than the creditors – is granted decision rights.

Recent research and public discourse on executive compensation and corporate governance suggests a growing consensus that firms can and should increase their control over top managers by increasing the use of managerial incentives and monitoring by boards of directors. This study departs from this consensus by offering an alternative perspective that considers not only the benefits, but also the costs of both incentives and monitoring in large corporations. The study develops and tests a contingency cost/benefit perspective on governance decisions as resource allocation decisions, proposing how and why the observed levels of managerial incentives and monitoring may vary across organizations and across time. Specifically, the study suggests that: (1) firms that are more risky face greater costs when using incentive compensation contracts for top managers, thus reducing the expected level of incentive compensation use for such firms; (2) firms facing this problem of low incentive compensation use can realize greater benefits from higher levels of board monitoring, and thus are likely to rely more on board monitoring; and (3) firms with more complex corporate strategies face higher costs in using board monitoring, and are thus likely to rely less on board monitoring as a source of controlling top management behavior.

Over the past 20 years, there has been a dramatic increase in the share of executive compensation paid through stock options. We examine the extent to which tax policy has inuenced the composition of executive compensation, and discuss the implications of rising stock-based pay for tax policy. We begin by describing the tax rules for executive pay in detail and analyzing how changes in various tax rates affect the tax advantages of stock options relative to salary and bonus. Our empirical analysis leads to three conclusions. First, there is little evidence that tax changes have played a major role in the dramatic explosion in executive stock-option pay since 1980. Although the tax advantage of options has approximately doubled since the early 1980s, options currently have only a slight tax advantage relative to cash—approximately $4 per $100 We thank James Poterba (the editor) for helpful suggestions, and compensation consul-tants Robert Greenberg and Scott Olsen (of Towers Perrin) and Fred Cook (of Frederic W. Cook and Company) for helpful insights and background information. We thank Paul