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Fama: Agency problems and the theory of the firm

Disclaimer. Don't rely on these old notes in lieu of reading the literature, but they can jog your memory. As a grad student long ago, my peers and I collaborated to write and exchange summaries of political science research. I posted them to a wiki-style website. "Wikisum" is now dead but archived here. I cannot vouch for these notes' accuracy, nor can I even say who wrote them. If you have more recent summaries to add to this collection, send them my way I guess. Sorry for the ads; they cover the costs of keeping this online.

Fama. 1980. Agency problems and the theory of the firm. Journal of Political Economy 88 (2).

Research Question

"To what extent can the signals provided by the managerial labor market and the capital market, perhaps along with other market-induced mechanisms, discipline managers?"

Place in the Literature

Alchian and Demsetz's model of the firm had the right idea, but failed to completely eliminate the entrepreneur from their theory:

"The striking insight of Alchian and Dernsetz (1972) and Jensen and Meckling (1976) is in viewing the firm as a set of contracts among factors of production. In effect, the firm is viewed as a team whose members act from self-interest but realize that their destinies depend to some extent on the survival of the team in its competition with other teams."

Fama criticizes Alchian and Demsetz, however, for failing to eliminate the entrepreneur from the picture; their theory still includes an employer who, like an entrepreneur, polices shirking because he collects the benefits of doing so.

Main Argument

Fama preserves Alchian and Demsetz's "set of contracts" perspective but eliminates the assumption that large firms have anything like an entrepreneur (there isn't anybody who owns everything AND manages the firm). Instead, the two functions entrepreneurs generally play--risk bearing and management--are instead carried about by separate actors. The firm is disciplined through competition, and individual members within the firm, "in particular its managers, face both the discipline and opportunities provided by the markets for their services, both within and outside of the firm."

Crucially, Fama sees a market for (a) risk-bearing and (b) management:

"The major loss in retaining the concept of the entrepreneur is that one is prevented from developing a perspective on management and risk bearing as separate factors of production, each faced with a market for its services that provides alternative opportunities and, in the case of management, motivation toward performance."

Owners can take their capital elsewhere for a better return; managers who do well can move up.


Research on similar subjects

Tags

Fama, Eugene (author)Political ScienceComparative PoliticsPrincipal-AgentFirmsRisk

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