A Theory of the Firm: Governance, Residual Claims, and Organizational Forms - Book Review

Administrative Science Quarterly, June, 2002 by Phillip H. Phan

Michael C. Jensen. Cambridge, MA: Harvard University Press, 2000. 311 pp. $47.50.

This book is a collection of eight previously published papers by Michael Jensen of the Harvard Business School and his coauthors in a stream of research dealing with agency theoretic formulations of the theory of the firm. It is aimed specifically at research scholars in financial economics, strategic management, organizational theory, and public policy. Because it is a collection, the papers tend to vary in style and technicality, from impassioned advocacy (chap. 3) to general narrative (chap. 2) to formal mathematical modeling (chap. 6). Deliberately little was done to reedit the papers for flow, and while this tends to give the reader mental whiplash as he or she tries to adjust between chapters, it maintains the integrity of the original thoughts that went into the original papers. It makes a good first book for Ph.D. students and scholars new to the field needing a quick summary of a half-century of theoretical development, and because only they would have the tenacity to plow through the formal models.

The ideas in the book are not new to scholars familiar to the field, but they do represent the theoretical cutting edge, which attests to the robustness of Jensen's ideas (chapter 4 was first published in 1976) or, to the more cynical, a lack of theoretical advancement. Because these ideas are brought together in one place, the book neatly presents the historical development and theoretical arguments for readers in a way that sorting through a bunch of papers cannot.

The main point the book makes is that one cannot build a complete theory of the firm, typically encountered in traditional production models, without giving special consideration to the governance mechanisms that ensure the efficient deployment of resources and distribution of wealth. For example, the book demonstrates the theoretical and practical importance of knowing the identity of the firm's owner. In classical theories of the firm, owners are merely suppliers of capital, homogenously risk averse and value maximizing. The book makes an oft-missed point in today's heady arguments over shareholder wealth maximization and corporate responsibility, however, that all parties to the contract called "the firm" have different risk preferences. For example, institutional owners may even have conflicting risk preferences, which can result in control issues, such as minority oppression, that do not arise in classical theory-of-the-firm formulations.

The book early on dismisses the usefulness of traditional conceptions of the firm as pure production functions. Instead, it reconstructs a theory of the firm on a positive agency theory foundation, arguing that it is the contractual relationship between the suppliers and users of capital and talent that determine what, how, and when production occurs. This framework brings together the following elements: (1) the importance of capital structure, i.e., debt/ equity mix and types, refuting Modigliani and Miller's (1958) irrelevance hypothesis, (2) the importance of governance structures, making Jensen one of the earliest to emphasize the important role of outside directors in the boardroom, (3) the role of transaction-specific and specialized knowledge, elevating the theoretical significance of the knowledge worker, (4) the importance of the residual claimant, centralizing the shareholder, and (5) the existence and nature of agency costs, which Jensen notes are inevitable between parties with asymmetric informa tion and different preference curves. This theoretical model is elegantly simple and yet powerful enough to deal with such diverse organizational structures as the owner-operated firm and the widely held multiunit public corporation. It is particularly suited to theoretical modeling on such topics as top management compensation, self-governing contracts, mutual monitoring at the firm and individual levels of analyses, distribution of residuals, hierarchy, and corporate takeovers.

The book makes a credible attempt to apply agency theory, without direct reference to sociological constructs, to different organizational forms, such as mutuals, partnerships, labor-managed organizations, cooperatives, owner-operated, substantially controlled, and the widely held public corporation. Chapter 6 is particularly interesting in this regard because it attempts to apply the theoretical framework to labor-managed organizations, most commonly seen in Communist political economies. The theory's conclusion that such systems are doomed to failure presages the collapse of the Soviet state and the ensuing adjustments toward free-market systems around the world.

The few problems with the book are inherent in the design of the volume. As a collection of articles, each of which were originally written as complete projects, the chapters tend to be repetitive. Chapters 2, 3, and 4 repeat the basic agency theory arguments. Without making substantive editorial changes, a simple reorganization of the chapters would have significantly helped the flow. Chapter 4 on agency theory should have been moved to chapter 2. Applications of agency theory to forms of capital, organization, production, and corporate control (chaps. 3, 5-8) could have followed. Jensen's 1993 speech to the American Finance Association (chap. 2) should have been moved to the conclusion. It serves as a fitting summary of the history of research and practice in corporate governance.