Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure
Michael C. Jensen
Harvard Business School
and
William H. Meckling
University of Rochester
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 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.
The directors of such [joint-stock] companies, however, being the managers rather of
other people’s money than of their own, it cannot well be expected, that they should
watch over it with the same anxious vigilance with which the partners in a private
copartnery frequently watch over their own. Like the stewards of a rich man, they are apt
to consider attention to small matters as not for their master’s honour, and very easily
give themselves a dispensation from having it. Negligence and profusion, therefore, must
always prevail, more or less, in the management of the affairs of such a company.
—    Adam Smith (1776)
Keywords: Agency costs and theory, itnernal control systems, conflicts of interest, capital
structure, internal equity, outside equity, demand for security analysis, completeness of
markets, supply of claims, limited liability
©1976 Jensen and Meckling
Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360.
Reprinted in Michael C. Jensen, A Theory of the Firm: Governance,
Residual Claims and Organizational Forms (Harvard University Press, December 2000)
available at hupress.harvard.edu/catalog/JENTHF.html
Also published in Foundations of Organizational Strategy,
Michael C. Jensen, Harvard University Press, 1998.
This document is available on the
Social Science Research Network (SSRN) Electronic Library at:
papers.ssrn/sol3/paper.taf?ABSTRACT_ID=94043

Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure
Michael C. Jensen
Harvard Business School
and
William H. Meckling*
University of Rochester
1.  Introduction
1.1. Motivation of the Paper
In this paper we draw on recent progress in the theory of (1) property rights, (2) agency,
and (3) finance to develop a theory of ownership structure1 for the firm.  In addition to tyinggovernance
together elements of the theory of each of these three areas, our analysis casts new light on and
has implications for a variety of issues in the professional and popular literature including the
definition of the firm, the “separation of ownership and control,” the “social responsibility” of
business, the definition of a “corporate objective function,” the determination of an optimal capital
structure, the specification of the content of credit agreements, the theory of organizations, and the
supply side of the completeness of markets problems.
1 We do not use the term ‘capital structure’ because that term usually denotes the relative quantities of
bonds, equity, warrants, trade credit, etc., which represent the liabilities of a firm.  Our theory implies there is
another important dimension to this problem—namely the relative amount of ownership claims held by
insiders (management) and outsiders (investors with no direct role in the management of the firm).
* Associate Professor and Dean, respectively, Graduate School of Management, University of Rochester.  An
earlier version of this paper was presented at the Conference on Analysis and Ideology, Interlaken,
Switzerland, June 1974, sponsored by the Center for Research in Government Policy and Business at the

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