Corporate governance and the theory of the firm are two of the fastest growing topics in modern economic theory. Berle and Means argued that modern corporations were so dependent upon professional managers that a managerial economy had emerged, characterized by the separation of ownership from control in corporations. The managers decided upon the running of the corporation whilst the shareholders, though they were the owners, were only entitled to receive cash flows. This leads to potential conflicts between the interests of the shareholders and those of the management. Following these two pioneering works, significant contributions have since been made in the areas of property rights theory (Hart and Moore, 1990), agency theory (Jensen and Meckling, 1976), the theory of incomplete contracts (Williamson, 1985), and transactions cost theory (Williamson, 1985). All these theories contribute from different angles to an understanding of the issues of corporate governance, and fundamentally affect our thinking about what is a firm and in whose interests the firm is governed.
[...] It is argued here that the reliance upon agency theory as a mechanism for managing a business is one of the problems which leads to the excesses referred to at the start of this article. It is therefore argued that the foundations of corporate governance in this environment are problematic. Bibliography: 1. Alchian, Armen and Harold Demsetz (1972), 'Production, Information Costs, and Economic Organisation', American Economic Review 62, 777- Berle, Adolfand Gardiner Means (1932), the Modern Corporation and Private Property, New York, Macmillan Hart, Oliverand John Moore (1990), 'Property Rights and the Nature of the Firm', Journal of Political Economy98, 1119- Himmelberg, C.P., R.G. [...]
[...] To ensure the agent works properly for the principal, the principal has to incur extra costs (non- pecuniary as well as pecuniary) - these are called the agency costs. Jensen and Meckling (p. 308) listed the agency costs as the sum of: 1. the monitoring expenditures of the principal; 2. the bonding expenditures by the agent, and 3. The residual loss The residual loss is the reduction in the value of the firm that comes about when the entrepreneur dilutes his ownership. [...]
[...] For this paper to attempt to fully cover these conflicts would be impossible, however, what is dealt with is some of the main research which has been conducted into the area of agency conflicts. Differing researchers have argued over the severity of each of the different types of conflicts described above. Research by Jensen (1986) and Himmelberg et al. (1999) amongst others stress the importance of a firm's contracting environment, as vitally important in determining the importance of such problems. [...]
[...] Hence, the control of agency problems in the decision process is important when the managers who initiate and implement important decisions are not the major residual claimants, and therefore do not bear a major share of the wealth effects of their decisions. Without effective control procedures, such managers are more likely to take actions that deviate from the interests of the residual claimants. An effective system for decision control implies, almost by definition, that the control (ratification and monitoring) of decisions is to some extent separate from the management (initiation and implementation) of decisions. [...]
[...] The result of this is an optimal level or residual loss, which may represent a trade-off between overly constraining management and enforcing contractual mechanisms designed to reduce agency problems. Jensen and Meckling (1976) are credited with the systematic use of principal-agent relations to characterise the problem of governing the relationship between shareholders and managers. Jensen and Meckling define an agency relationship as a contract under which one or more persons (the principals) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent (p. 308). [...]
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