Why Do Agency Theorists Misinterpret Market Monitoring?

Abstract

Separation of ownership and control is the main governance problem facing the modern corporation (Adam Smith, 1776, Berle and Means, 1932, Jensen and Meckling, 1976). With no one to care for passive outside investors, large and liquid companies should not exist. I hypothesize that informed speculators fulfill this role by monitoring management. Indeed, in the manager’s optimal contract, I show that stock price weight (inside ownership) must fall with more informative stock prices and scale. Holmstrom and Tirole (1993) seems to rule out this monitoring explanation by its (false) finding that monitoring gives rise to high- not low-powered incentives.

Keywords: Pay-Performance Sensitivity, Governance Through Trading, Agency, Incentives, External Monitoring

JEL Classification: G34, J41, J44, L25