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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 'separation and control' issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears the 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.

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

Abstract:
Understanding human behavior is fundamental to understanding how organizations function, whether they are profit-making firms, non-profit enterprises, or government agencies. Much disagreement among managers, scientists, policy makers, and citizens arises from substantial differences in the way we think about human nature--about their strengths, frailties, intelligence, ignorance, honesty, selfishness, and generosity. In this paper we discuss five alternative models of human behavior that are commonly used (though usually implicitly). They are the Resourceful, Evaluative, Maximizing Model (REMM), Economic (or Money Maximizing) Model, Psychological (or Hierarchy of Needs) Model, Sociological (or Social Victim) Model, and the Political (or Perfect Agent) Model. We argue that REMM best describes the systematically rational part of human behavior. It serves as the foundation for the agency model of financial, organizational, and governance structure of firms.

The growing body of social science research on human behavior has a common message: Whether they are politicians, managers, academics, professionals, philanthropists, or factory workers, individuals are resourceful, evaluative maximizers. They respond creatively to the opportunities the environment presents, and they work to loosen constraints that prevent them from doing what they wish. They care about not only money, but about almost everything--respect, honor, power, love, and the welfare of others. The challenge for our society, and for all organizations in it, is to establish rules of the game that tap and direct human energy in ways that increase rather than reduce the effective use of our scarce resources.

See also the related paper by Jensen Self Interest, Altruism, Incentives, and Agency Theory.

Human behavior, Rationality, Altruism, Self Interest, Perfect Agents, Sociology, Agency Costs

Abstract:
Our purpose in this paper is to examine divisional performance measurement methods and related aspects of the rules of the game that govern the behavior of managers. Performance measurement is one of the critical factors that determine how individuals in an organization behave. It is one aspect of what we call the organizational rules of the game, which consist of (1) the performance measurement and evaluation system, (2) the reward and punishment system, and (3) the system for partitioning decision rights among individuals in an organization.

Performance measurement includes the objective and subjective assessments of the performance of both individuals and subunits of an organization such as divisions or departments. Performance evaluation is the process of attaching value weights to various measures of performance to represent the importance of achievement on each dimension.

The reward and punishment system relates the rewards granted to individuals to results measured by the performance measurement system. Rewards and punishments include nonmonetary factors such as honor, attention, and rank, as well as monetary factors such as salary changes and bonuses.

We analyze the peculiar characteristics of common divisional performance measures associated with what are often called cost centers, revenue centers, profit centers, investment centers and EVA and expense centers. We analyze the counterproductive incentives induced by these various performance measures and the conditions under which each of them could be sensibly used in an organization.

Abstract:
This paper analyzes the relations between knowledge, control and organizational structure both in the market system as a whole and in private organizations. Limitations on the mental capacity of the human mind and the costs of producing and transferring knowledge means that knowledge relevant to all decisions can never be collected in the mind of a single individual or a small body of experts. This means that if the knowledge valuable to a particular decision is to be used in making that decision, there must be a system for partitioning out decision rights to individuals who already have the relevant knowledge and abilities or who can acquire or produce them at the lowest cost. Self interest on the part of individual decision-makers means a control system is required to motivate individuals with the decision rights and the relevant knowledge to use those decision rights appropriately. This control problem is solved in a capitalist economy by a system of alienable property rights.

Alienable rights cannot generally solve the control problem in firms, and the assignment of decision rights in firms does not generally include the assignment of alienability. Indeed, this is one of the major distinctions between firms and markets. The inalienability of rights within an organization means control problems must be solved by alternative means. Organizations solve these problems by establishing what we define to be the Organizational Rules of the Game that provide:

(1) a system for partitioning decision rights out to agents in the organization, (2) a performance measurement and evaluation system, and (3) a reward and punishment system

The inherent inefficiency of organizational control systems as compared to alienability means firms cannot survive unless they provide other offsetting advantages such as economies of scale, scope or riskbearing.

Abstract:
In Coordination, Control, and the Management of Organizations (CCMO) we periodically hand out an abbreviated set of course notes to students that follow reasonably closely the class schedule and discussions in the first half of the course. The notes are designed to help students organize the main points of the class discussions and their own notes, and are not intended to be a stand-alone text (although that project is underway). These notes were first created in the mid-1970s by Jensen and Meckling for use in their CCMO course at the Rochester's Simon School of Business. Three faculty at Rochester involved in the course have published a written and somewhat supplemented version of the Course Notes as they were left in 1989 on Jensen's departure from Rochester. The notes have continued to evolve over time with the course and with the contributions of fellow teaching faculty George P. Baker and Karen H. Wruck.

We hand out the notes in two parts after we have completed discussion of the material. We have found that class discussions and learning are vastly improved if the notes are available to the students only after they have read and discussed the material. We ask students not to use notes from past semesters, to treat the notes in the same way they would treat information from fellow students in an earlier class or in an exam and not to distribute the notes to others.

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The CCMO materials are presented in four electronic documents entitled as follows (you can go directly to each document and its abstract by clicking on the title below):

1. Organizations and Markets: History and Development of the Course and the Field, by Michael C. Jensen, George P. Baker, Carliss Y. Baldwin, and Karen H. Wruck, Dec. 10, 1997 (forthcoming in "The Intellectual Venture Capitalist: John H. McArthur and the Work of the Harvard Business School," 1980-1995, Thomas K. McCraw and Jeffrey L. Cruickshank, eds, (Harvard Business School Press, 1998)).

2. This document -- Coordination, Control, and the Management of Organizations: Course Notes, by Michael C. Jensen and William H. Meckling, with contributions from George P. Baker and Karen H. Wruck, April 20, 1998, Harvard Business School Working Paper.

3. Coordination, Control, and the Management of Organizations: Course Content and Materials, by Michael C. Jensen and Karen H. Wruck, April 20, 1998, unpublished manuscript, Harvard Business School.

4. Coordination, Control, and the Management of Organizations: Practice Questions, by Michael C. Jensen, William H. Meckling, George P. Baker, and Karen H. Wruck, with contributions from Carliss Y. Baldwin, and Malcolm S. Salter, April 20, 1998, unpublished manuscript, Harvard Business School.

Return to main CCMO abstract.

Abstract:
This document contains a collection of 99 exam questions from the last 20 years of the Coordination, Control, and the Management of Organizations (CCMO) course. They are given to students at the end of the semester as a vehicle to aid their study for the final exam. These questions are a combination of stand-alone questions and questions that accompany journal and magazine articles. They are organized with the most recent exam questions last, so we recommend that readers start from the last questions and move toward the front of the document in their study.

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The CCMO materials are presented in four electronic documents entitled as follows (you can go directly to each document and its abstract by clicking on the title below):

1. Organizations and Markets: History and Development of the Course and the Field, by Michael C. Jensen, George P. Baker, Carliss Y. Baldwin, and Karen H. Wruck, Dec. 10, 1997 (forthcoming in "The Intellectual Venture Capitalist: John H. McArthur and the Work of the Harvard Business School," 1980-1995, Thomas K. McCraw and Jeffrey L. Cruickshank, eds, (Harvard Business School Press, 1998)).

2. Coordination, Control, and the Management of Organizations: Course Notes, by Michael C. Jensen and William H. Meckling, with contributions from George P. Baker and Karen H. Wruck, April 20, 1998, Harvard Business School Working Paper.

3. Coordination, Control, and the Management of Organizations: Course Content and Materials, by Michael C. Jensen and Karen H. Wruck, April 20, 1998, unpublished manuscript, Harvard Business School.

4. This document -- Coordination, Control, and the Management of Organizations: Practice Questions, by Michael C. Jensen, William H. Meckling, George P. Baker, and Karen H. Wruck, with contributions from Carliss Y. Baldwin, and Malcolm S. Salter, April 20, 1998, unpublished manuscript, Harvard Business School.

Return to main CCMO abstract.

Abstract:
In this article we review the implications of the Nader proposals for Taming the Giant Corporation and the related campaigns for economic and corporate democracy. These campaigns, if successful, would impose costs on one group for the benefit of others, reduce economic efficiency and wealth, and finally would reduce, not increase, freedom.

Corporate democracy advocates would impose restrictions on the freedom of individuals to associate, contract, and produce through the corporate form. In doing so they often use the analogy with the political state to buttress their arguments without coming to grips with the essential difference between the government (whether local, state or federal) and a corporation: Only a governmental has the legal monopoly over the use of physical coercion and violence on individuals (including arrest and imprisonment) to compel compliance with the dictates of the state. No corporation no matter how large has the police powers. No corporation has the legal right to use violence to compel any individual to buy from it, sell to it, invest in it, or work for it.

We offer a new definition of freedom. Maximal freedom exists in a society if: (1) the rights system passes on to individuals the full set of opportunities provided by nature, and (2) the state enforces its monopoly over violence, and (3) each person has exclusive rights in his or her body. In this system the state is required to use coercion and violence to enforce the rights which resolve the physical incompatibility problem, and to maintain the state's monopoly over the use of violence.

In conclusion we call on the various public interest lawyers and organizations to use their resources to increase freedom and aggregate welfare. They can do this by focusing their resources on preventing the use of the police powers for private benefit, for wealth confiscation, and for political theft.

definition of freedom, economic democracy, corporate democracy, corporategovernance, role of government, contracting, federal chartering, violence, police powers, rights

Abstract:
It is traditional in the theory of the firm to define the production opportunity set available to the firm in terms of its boundary the maximum attainable set of output quantities for various input quantities, given the state of technology and knowledge. This boundary is the production function of the firm. One of our purposes here is to point out the dependence of such production functions on the structure of property rights and contracting rights within which the firm exists. We redefine the production function in order to recognize the dependence of output on the structure of property and contracting rights. That expanded framework is then used to discuss a concrete set of problems surrounding the role of labor in the firm ranging from the labor-managed firm system (in which tradable capital value residual claims [common stock] are legally prohibited), and the codetermination and industrial democracy movements (in which management participation by labor is required by law), to cooperatives and professional partnerships (i.e., quasi-labor-managed firms which arise out of the voluntary contracting process), and the capitalist corporation.

Labor Managed Firm, Property Rights, Contract Rights and Production Functions, Rules of the Game, Nexus of Contracts, Codetermination, Industrial Democracy, Cooperatives and Professional Partnerships

Abstract:
One of the tactics politicians use in their quest for power is to draw a false distinction between human rights and property rights. Property rights are, in the last analysis, rights of individuals. As investors, who have a direct stake in the property rights of corporation, become less certain that society will honor those rights, the capitalized values of corporate securities will erode - ultimately to the point that many corporations will be able to remain in business only so long as they can finance their operations from internally generated cash flow or public subsidy.

Rights, regulation, private enterprise, contracts, rights, regulation, private enterprise, contracts

Abstract:
This paper discusses five common divisional performance measurement methods - cost centers, revenue centers, profit centers, investment centers, and expense centers - while providing a theory that explains when each of these methods is likely to be the most efficient. The central insight of the theory is that each method offers a different way of aligning decision-making authority with valuable 'specific knowledge' inside the organization.

The theory suggests that cost and revenue centers work best in cases where headquarters has good information about cost and demand functions, product quality, and optimal output mix. Profit centers - defined as business units whose managers have responsibility for overall profits, but not the authority to make major capital spending decisions - tend to supplant revenue and cost centers when line managers have a significant informational advantage over headquarters and when there are few interdependencies (or 'synergies') between divisions. Investment centers - profit centers in which unit managers are allowed to make major investment decisions - tend to prevail when the activity is capital-intensive and when it is difficult for headquarters to identify the value-maximizing investment strategy for the business unit.

In evaluating the performance of profit centers, rate-of-return measures like ROA are likely to be effective when unit managers do not have major influence over the level of new investment. But, in the case of investment centers, Economic Value Added, or EVA, is likely to be the most effective single-period measure because it is designed to encourage only value-increasing investment decisions.

Performance measurement, cost center, profit center, investment center, expense center, specific knowledge, general knowledge

Abstract:
In evaluating the performance of profit centers, rate-of-return measures like ROA are likely to be effective when unit managers do not have major influence over the level of new investment. But, in the case of investment centers, Economic Value Added, or EVA, is likely to be the most effective single-period measure because it is designed to encourage only value-increasing investment decisions.The theory suggests that cost and revenue centers work best in cases where headquarters has good information about cost and demand functions, product quality, and optimal output mix. Profit centers - defined as business units whose managers have responsibility for overall profits, but not the authority to make major capital spending decisions - tend to supplant revenue and cost centers when line managers have a significant informational advantage over headquarters and when there are few interdependencies (or “synergies”) between divisions. Investment centers - profit centers in which unit managers are allowed to make major investment decisions - tend to prevail when the activity is capital-intensive and when it is difficult for headquarters to identify the value-maximizing investment strategy. This classic by the formulators of agency cost theory discusses five common divisional performance measurement methods - cost centers, revenue centers, profit centers, investment centers, and expense centers - while providing a theory that attempts to explain when each of these methods is likely to be the most efficient. The central insight of the theory is that each method offers a different way of aligning decision-making authority with valuable “specific knowledge” inside the organization.

The theory suggests that cost and revenue centers work best in cases where headquarters has good information about cost and demand functions, product quality, and optimal output mix. Profit centers - defined as business units whose managers have responsibility for overall profits, but not the authority to make major capital spending decisions - tend to supplant revenue and cost centers when line managers have a significant informational advantage over headquarters and when there are few interdependencies (or “synergies”) between divisions. Investment centers—profit centers in which unit managers are allowed to make major investment decisions - tend to prevail when the activity is capital-intensive and when it is difficult for headquarters to identify the value-maximizing investment strategy.

In evaluating the performance of profit centers, rate-of-return measures like ROA are likely to be effective when unit managers do not have major influence over the level of new investment. But, in the case of investment centers, Economic Value Added, or EVA, is likely to be the most effective single-period measure because it is designed to encourage only value-increasing investment decisions.

Abstract:
The corporation as an organizational form is an enormously productive social invention. Partly because of its success it is under increasing attack from various quarters, often under the guise of protecting investors from self-interested managers. Some of these attacks are successful simply because the corporation is a poorly understood entity. This paper discusses what the corporation is, what it is not, and how certain misconceptions about the corporate form are fostered by its critics as part of their attack.

Social responsibility, survival, definition of corporation, corporate democracy, federal chartering, Corporate Democracy Act, corporate control, government involvement

Abstract:
We develop a framework that is applicable to all freedom of expression disputes. Our framework is based on the meaning of freedom which is based on the meaning of scarcity, and which, in turn, is based on the existence of physical incompatibilities. To maximize freedom, one must differentiate between scarce and non-scarce rights. Scarce rights can not be granted to everyone because of natural limitations caused by physical incompatibilities. If one person burns a tree for warmth, another cannot use the tree to build a house. Conflicts caused by such physical incompatibilities are resolved peacefully by giving exclusionary rights in the physical use of the tree to a single, private party. These are scarce rights because more than one person cannot use the tree when there are physical incompatibilities. Non-scarce rights, in contrast, can be granted to everyone. The contents of one's speech, for example, in no way limits what other people can may say or do. To maximize freedom, each scarce right must be assigned to some individual person, and all non-scarce rights should be assigned to everyone. We use this framework to provide an integrated and consistent analysis of prominent Supreme Court rulings on free speech issues, including public access to government and private property, symbolic speech (including flag burning), libel, and obscenity.

Freedom, First Amendment, property rights, externality, physical incompatibility, scarce rights, non-scarce rights, constitutional law

Abstract:
The right to bring an action in court is an important right which many argue should be granted liberally. The United States Supreme Court, for example, has held that under certain situations access to court is a citizen's fundamental right. This paper discusses one facet of access to the courts, namely, standing to sue: the legal doctrine shaped by both courts and legislatures which determines who can bring a particular lawsuit.

Discussions of standing have tended to focus on normative arguments about what standing should be while often neglecting positive implications of alternative standing doctrines. Standing doctrines that either increase or decrease access to court have predictable consequences relevant to the Supreme Court's admonition that standing decisions should be predicated not only upon constitutional considerations but also on practicalities and prudential consequences. Our analysis shows that many liberalizations of standing block the transfer of resources from less valuable to more valuable uses. In that regard they are, to use the Supreme Court's language, impractical and imprudent. In economic terms, standing that is too liberal generates inefficiencies.

Section I explores the different consequences of polar standing rules: A rule that allows only one person standing in a particular suit is contrasted with a rule that allows everyone standing. Here, as in most of the paper, the analysis focuses on private lawsuits and ignores lawsuits brought against public officials. Section II summarizes the relevant literature and reviews the liberalizations of standing over the past twenty years. Section III discusses the largely unrecognized relationship between restrictive standing, alienable rights, and efficiency; also reviewed here are class action lawsuits and standing to sue public officials. Section IV contains the conclusions.

standing, legal doctrine, U.S. Supreme Court, rights, efficiency, transaction costs, alienability

Abstract:
Is there a fundamental conflict between a political democracy as we know it and a free market, private enterprise or capitalist system ? William Meckling and Michael Jensen of the University of Rochester, New York, believe that indeed there is, and that it is only a matter of time before the political sector eliminates most of the freedoms we still enjoy in the private sector of the economy.

The first part of this study, contributed by Michael Jensen, describes the gradual destruction of individuals" rights and the attack on business corporations; the second part, by William Meckling, discusses why freedom is being destroyed, how the press helps governments to destroy it, and what can be done to stop it.

rights, freedom, free market, private enterprise, political democracy, human rights, property rights, co-determination laws

Abstract:
With the possible exception of love, probably no word in the English language generates a more sympathetic response than the word freedom. Everyone favors freedom. We prize it not only for ourselves, but also as a characteristic of our society. Most of us, however, have given little thought to what we mean by freedom. We use it to describe virtually everything we believe is good or right. Freedom is a hurrah word. Advocates of all persuasions characterize their programs as enhancing freedom. In the extreme, we find spokesmen for the most tyrannical states boldly claiming that theirs is true freedom because it provides freedom from want, a logic equivalent to arguing that prisoners are free as long as they are well fed and sheltered.

Any unambiguous conception of freedom should distinguish between choices such as 1) Give me $20 and I'll give you a sirloin steak, and 2) Give me your wallet or I'll shoot you with the gun I have pointed at your midsection. These transactions both give you a choice. One might be tempted to say that the second is inconsistent with freedom because the choice I'm giving you makes you worse off. But there are many transactions that seem perfectly consistent with, and even required by, freedom that have this characteristic. Consider the offer I make you on the expiration of your lease of my property: Give me a monthly rental of 10% more than our previous arrangement or move out.

freedom, capitalism, human rights, definition of rights, nature, constraints, definition of freedom, contracts, power, rights

Abstract:
This article examines unrecognized implications of various doctrines governing access to court. The analysis indicates that doctrines such as standing, res judicata and collateral estoppel have far reaching implications for the nature of adjudication and the basic structure of rights in society. A liberal standing doctrine causes Peremptory Adjudication, creates inalienable rights and erodes the common law doctrine against suing competitors. Inalienability of rights causes the Coase Theorem to fail and creates externalities. Furthermore, allowing suit over non-contractual pure value effects creates closed market monopolies. All these factors reduce efficiency and thereby reduce human welfare. In this sense the analysis (1) indicates the widespread enthusiasm for democratization of the courts is mistaken, and (2) provides the case for restricting access to the courts.

standing, stare decisis, res judicata, collateral estoppel, Coase Theorem, courts, legal system, efficiency, adjudication, rights, externalities

Abstract:
Why do we so often find the press carrying glowing stories of the benefits derived from governmental programs such as urban renewal (often-times even when they are in the process of failing miserably)? In view of this, why are we so seldom treated to glowing reports by the press about how a housing developer, for example, has improved the standard of living of 5,000 families by planning and completing a new subdivision of 5,000 homes? - a feat made no less remarkable (as compared to urban renewal) through its accomplishment by voluntary exchange!

Or to put the issue in its starkest form: Why is it that the public at large is so basically antagonistic towards markets in general? There exists in many, if not most people, a deep seated belief that man should not be motivated by monetary rewards. This belief is reflected in many cultural traditions, one of which is called the Golden Rule. We believe a major element in the determination of these attitudes is the structure of the family, in particular the way in which we raise children and the reflection of these values in religious dogma.

Family, values, markets, Golden Rule, press

Abstract:
Develops a theory of firm-ownership structure using elements from the theories of agency, property rights, and finance. The concept of agency costs is defined and its relationship to the "separation and control" issue is shown. In addition, the nature of the agency costs generated by debt and outside equity is investigated and both the individuals responsible for assuming these costs, and why they bear them, are identified. The evidence, demonstrated in the model used to explain the existence of minority shareholders and debt in the capital structure of corporations, implies that the owner-manager will have his entire wealth invested in the firm before he resorts to any outside funding. However, this evidence is not consistent with general observations of owner-managers--most owner-managers hold personal wealth in many forms and some invest only a fraction of their wealth in the corporation they manage. In addition, it is shown that the owner's fractional claim on the firm decreases as the amount of outside equity increases and that this causes the owner to take additional non-pecuniary benefits out of the firm because his share of the cost falls. Also, as the fraction of outside financing increases, the locus of agency costs shift upward. The agency cost of debt will rise similarly as the amount of outside financing increases. This leads to the hypothesis that, the larger the firm becomes, the larger the total agency costs because the monitoring function is likely to be more difficult and expensive in a larger organization. (SFL)

Agency costs, Operator ownership, Firm ownership, Organizational structures, Property rights, Debt financing, Capital structure, Organization theory, Agency theory, Firm financing, Shareholders