A Theory of the Firm: Governance, Residual Claims and Organizational Forms [Hardcover]

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 (chapter 3) to general narrative (chapter 2) to formal mathematical modeling (chapter 6). Deliberately little was done to reedit the papers for flow and while this tends to give the reader mental whiplash as he 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 Prof. Jensen's ideas (chapter four was first published in 1976) or to the more cynical - a lack of theoretical advancement. Because they are brought together in one place, the book neatly presents the historical development and theoretical arguments 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 special consideration for 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 however makes an oft-missed point in today's heady arguments over shareholder wealth maximization and corporate responsibility 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: a. The importance of capital structure, i.e., debt/equity mix and types, refuting Modigliani and Miller's (1958) irrelevance hypothesis, b. The importance of governance structure, making Jensen one of the earliest to emphasize the important role of outside directors in the boardroom, c. The role of transaction specific and specialized knowledge, elevating the theoretical significance of the knowledge worker, d. The importance of the residual claimant, centralizing the shareholder, and e. The existence and nature of agency costs, which Jensen notes are inevitable between parties with asymmetric information 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 to the widely held multi-unit public corporation. It is particularly suited to theoretical modeling 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 also makes a credible attempt to apply agency theory, without direct reference to sociological constructs, to different organizational forms such as mutuals, partnerships, labor-managed, cooperatives, owner operated, substantially controlled, and the widely held public corporation. Chapter six is particularly interesting in this regard because it attempts to applying the theoretical framework to labor managed organizations, most commonly seen in Communist political economies. The original paper'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.