Michael Jensen and William Meckling began their famous article, “Theory of the firm: managerial behavior, agency costs, and ownership structure”, which was published in the Journal of Financial Economics in 1976, with a quotation from Adam Smith’s The Wealth of Nations:

The directors of such 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 co-partnery 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 ) An Inquiry into the Nature and Causes of the Wealth of Nations. Book V, Chapter 1, Part III

This much-quoted paragraph appears towards the end of Smith’s book in a chapter entitled On the expenses of public works and public institutions, which discusses a series of topics that modern economists still wrestle with: the provision of public goods such as roads, bridges, canals, and harbours; collective action problems, where the costs of actions which benefit many fall disproportionately on a few; monopolies—which should be permitted, which discouraged, and how they should be regulated; and agency problems in public corporations, where costs arise because of the different interests of stockholders and managers. Two of these topics—agency problems and collective action—lie at the heart of this short book.

In the language of modern economic theory, agency costs arise when one or more person(s), the principal(s), engage(s) another person or persons, the agent(s), to perform some activity on their behalf, such that decision-making authority is substantially delegated by the principal to the agent. If both persons are utility maximisers, then there is good reason to believe that the agent will not always act in the interests of the principal, resulting in costs—agency costs—which are typically borne by the principal. A specific example of a principal-agent relationship, according to modern economists, is the contractual arrangement between the shareholders and managers of a public corporation.¹

Adam Smith argued that because the managers of a public corporation do not have the same proprietorial interests as (active) partners in a (trading) partnership they could not be expected to exercise the same level of care and attention in their management of the enterprise. The inevitable result, he concluded, is “negligence and profusion” or, in other words, ineffectiveness and inefficiency. He goes on to argue that joint-stock companies have seldom succeeded without “excessive privilege”, such as monopoly trading rights, and he suggests that, even when granted such excessive privilege, they have often mismanaged their enterprises. Adolf Berle (a lawyer and legal scholar) and Gardiner Means (an economist and Berle’s one-time research assistant) reached a similar conclusion in their seminal text The Modern Corporation and Private Property,² which examines the nature of ownership and control of large corporations in the United States in the 1930s. They argued that the dispersal of shareholdings in public corporations fundamentally undermined the unity of property rights. Small shareholders holding only fractional property rights over corporations had little incentive or ability to influence the day-to-day management of a company or to hold the managers accountable. Berle and Means identified three different types of relationship comprised in any enterprise: (1) “having an interest in” (in the sense of “Person X has an interest in Enterprise E”, i.e., some kind of legal property right); (2) “having power over” (“X has power over E”, i.e., de facto possession and control, in the sense of “possession being nine-tenths of the law”); and (3) “acting with respect to” (in other words, “managing”, in the sense of “X has the right to manage the day-to-day activities of E”). They go on to describe the evolution of the modern corporation in North America in the following terms. Before the industrial revolution, (1), (2), and (3) were combined and held by the same person or persons. In the nineteenth century, (3) became separated from (1) and (2) with the rise of the professional manager in, for example, the railroad, oil, and steel industries; however, legal and de facto ownership, that is, (1) and (2), remained firmly in the hands of the industrial barons—the Vanderbilts, Rockefellers, Carnegies, and others. In the twentieth century the dispersion of stock ownership over ever-greater numbers of stockholders caused “interest in”, that is, (1) to become separated from “power over”, that is, (2), so that stockholders became, in the words of Berle and Means, “owners without appreciable control”. This power vacuum encouraged managers to exercise greater influence over the enterprises that they managed, described by Berle and Means as “control without appreciable ownership”.³

It might be said that The Modern Corporation and Private Property is long on analysis of the problems of dispersed ownership but relatively short on possible recommendations. Berle and Means do describe (remembering again that they were writing in the early 1930s) three possible futures. First, the traditional logic of property rights, whereby corporations “belong” to their shareholders, might be substantially reinforced, such that managers controlling corporations are placed explicitly in the position of trustees who are required to operate the corporation for the sole benefit of shareholders; although Berle and Means are silent on the point, this would presumably require corporate law and securities regulation to be tightened to make these objectives specific. Alternatively, the inexorable logic of laissez-faire economics and pursuit of the profit motive might lead to “drastic conclusions”:

If, by reason of these new relationships, the men in control of a corporation can operate it in their own interests, and can divert a portion of the asset fund of income stream to their own uses, such is their privilege. Under this view, since the new powers have been acquired on a quasi-contractual basis, the security holders have agreed in advance to any losses which they may suffer by reason of such use.⁴

To put it another way, if shareholders’ reasonable expectations are satisfied in terms of (1) receiving regular dividends and (2) having the ability to release the value of their shares at any time by selling them on a stock market, then the rent-seeking activities of managers should be regarded as an inevitable and acceptable cost of investing in company shares. This hardly seems a desirable conclusion.

However, Berle and Means do also briefly set out a third possibility, which is frequently overlooked.⁵ This is that public corporations could be run in the interests of society as a whole, rather than primarily in the interests of shareholders and managers:

When a convincing system of community obligations is worked out and is generally accepted, in that moment the passive property right of today must yield before the larger interests of society. Should the corporate leaders, for example, set forth a program comprising fair wages, security to employees, reasonable service to their public, and stabili...