Organization Theory and Methodology -...

THE ACCOUNTING REVIEWVol. LVIII, No. 2April 1983

Organization Theory andMethodology

Michael C, Jensen

ABSTRACT: The foundations are being put in place for a revolution in the science oforganizations. Some major analytical building blocks for the development of a theory oforganizations are outlined and discussed in this paper. This development of organizationtheory will be hastened by increased understanding of the importance of the choice ofdefinitions, tautologies, analytical techniques, and types of evidence. The two literaturesof agency theory are briefly discussed in light of these issues. Because accounting is anintegral part of the structure of every organization, the development of a theory of organiza-tions will be closely associated with the development of a theory of accounting. Thistheory will explain why organizations take the form they do, why they behave as they do,and why accounting practices take the form they do. Because such positive theories asthese are required for purposeful decision making, their development will provide abetter scientific basis for the decisions of managers, standard-setting boards, and govern-ment regulatory bodies.

I. INTRODUCTION

A major challenge facing social scien-/ \ tists is the development of a body

X A . of theory to explain why organi-zations take the form they do and whythey behave as they do. My objective isto outline some aspects of this emergingline of research on organizations and tocall attention to a number of relatedmethodological issues that play an im-portant role in this research: the relationbetween positive and normative theories,the importance to the research effort ofthe choice of tautologies and definitions,the natiire of evidence, and the role ofmathematics. I conclude with a briefdiscussion of the two literatures of agencytheory.

I have two basic propositions thatdirectly bear on accounting:

(1) Accounting is an integral part ofthe structure of every organization,and

(2) a fundamental understanding of

why accounting practices evolve asthey do and how to improve themrequires a deeper understandingabout organizations than nowexists in the social sciences.

By way of background, I shall digressbriefly to discuss the relation betweenpositive and normative research.

II. POSITIVE AND NORMATIVE THEORYAND DECISION MAKING

In the period prior to the mid-1970'saccounting theory was predominantlynormative. It focused on policy prescrip-

I am indebted to Charles Christenson, Robert Kaplan,and to my colleagues, George Benston, Andrew Christie,Ann Coughlan, Martin Geisel, Clifford Holdemess,John Long, William Schwert, Clifford Smith, Ren6Stulz, Jerold Warner, and especially Ross Watts,William Meckling and Jerold Zimmerman for theircomments and suggestions.

Michael C. Jensen is Professor andDirector, Managerial Economics Re-search Center, University of Rochester.

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tions for management or public policy—questions involving the appropriate treat-ment of inflation, exchange rates, inven-tories, leases, and so on. These policyquestions are, of course, both interestingand important, and they are best an-swered with knowledge of a wide rangeof positive theory—that is, knowledgeabout how the world behaves. Forexample, accountants have been justi-fiably concerned with the effects of Gen-eral Price Level Adjusted accounting(GPLA) on accounting numbers. But amanager interested in maximizing thevalue of his firm also must estimate eitherexplicitly or implicitly how such ac-counting procedures will affect firmvalue. And how GPLA affects firm valueis a purely positive issue in the sense thatthe term is used in the social sciences.*Normative questions take the form:"How should price level changes bereflected in the accounting statements?"Positive questions take the form: "Howdoes GPLA affect the value of the firm?"Answers to normative questions alwaysdepend on the choice of the criterion orobjective function which is a matter ofvalues. Therefore, normative proposi-tions are never refutable by evidence.Answers to positive questions, on theother hand, involve discovery of someaspect of how the world behaves and arealways potentially refutable by contra-dictory evidence.

Considerable discussion and disagree-ment have occurred over methodologicalissues associated with the emerging hter-ature on positive accounting theory, andmy purpose here is to try to clarify someof these issues. In the end, of course, weare all interested in normative questions;a desire to understand how to accomplishgoals motivates our interest in thesemethodological topics and in positivetheories.

An interesting relationship between

normative and positive issues often goesunrecognized. Consider the general struc-ture of a decision problem:

j , Z 2 , . . . , Z ^ ) {A'l,X2, . . . ,Subject to the following constraints:

Accounting and otheridentities (such as budgetconstraints, time con-straints, etc.)

Positive theoriesYi =fi(Xi, X2, • • •, Xf^;

2,

Zi, Z2, . . .

where V is the objective function to bemaximized, the Z's are the decision vari-ables, the y's are the arguments of theobjective function that are determinedwithin the system (the "endogenous"variables), and the Z's are the variablesdetermined outside the system (the "exo-genous" variables).

The constraints of the problem are ofgreat interest here, and we can breakthem into two general categories. Thefirst category contains all accounting andother identities (such as budget con-straints, time constraints [24 hours in aday] and so on). The second category of

' The use of the term "positive" in this context hashad the unfortunate effect of linking accounting re-searchers who have been engaged in the effort to develop"positive" theories with "logical positivism," a schoolof thought in philosophy which has been controversial.The proposal to focus on positive theories of accountingdoes noi coinmii IIIOM.' \NIIO piupoNC ii in logi>.,il poM-tivism.

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constraints given by the functions, fi,determine how the decision variables, X,and the exogenous variables, Z, affectthe values of the endogenous variables,Y, in the objective function.

The second set of constraints is madeup of positive theories about the way theworld works :̂ for example, how deci-sions on accounting practices, organiza-tional structure, advertising, pricing, andproduction policies combine with physi-cal laws affecting production and theexogenous variables such as weather,interest rates, governmental regulatorypolicies, and human behavior to deter-mine the endogenous variables, Y, thataffect the value of the firm. Suppose thevalue of the firm is a function of expectednet cash fiows, their riskiness and theinterest rate. To choose among alterna-tive accounting policies, a manager de-siring to maximize the value of the firmwants to know how those alternativechoices affect the expected net cash fiowsand their riskiness. Answers to suchquestions require positive theories.

Positive theory enters the decisionprocess in one more way. While thechoice of the objective or maximand(firm value in our example) is a valuejudgment and therefore a normativeissue, knowledge of the valuation func-tion itself (that is, the function that relatesthe value of the maximand to the valuesof the endogenous and exogenous vari-ables) is a positive issue and requires atheory.

It is obvious from the logical structureof decision making that purposeful de-cisions cannot be made without theimplicit or explicit use of positive theo-ries. You cannot decide what action totake and expect to meet your objective ifyou have no idea about how alternativeactions affect the desired outcome—andthat requires positive theory. Further-more, using incorrect positive theories or

ignoring important constraints leads todecisions that have unexpected and un-desirable outcomes. This is equally truefor the manager, the auditor, the FASBor the governmental regulatory body.

The history of operations researchprovides an interesting example of theimportance of positive theories. I believea major reason for the early successes ofoperations research and its later failureto live up to the promise offered by thosesuccesses can be traced to the nature ofthe theories given emphasis in thoseefforts. The operations research litera-ture seems to evidence careful attentionto the constraints that positive physicalor engineering theories impose on de-cision making. When such physical phe-nomena are the dominant constrainingforce, ignoring other constraints givenby market forces, information costs, andthe peculiarities of human behavior canstill lead to highly successful results.Witness the successes in using linearprogramming to help run oil refineries orto solve feed-mixture problems. In theseproblems prices could reasonably betaken as fixed because of the competitivenature of the markets involved. Further-more, the fact that human beings do notalways do what they are told or even dowhat they agree to do is less importantin a highly mechanized process. In thissense refining and diet problems, wheremost of the important constraints in-volve chemical or other physical phe-nomena, are very special. The applicationof operations research to marketing andfinance and to the management of peoplehas been less successful. The paucity ofsuccessful applications in these areasstems not from deficiencies in the tech-niques or lack of technical expertise, butfrom the fact that researchers generally

^ And often involve the result of other individuals'maximization process.


ignored the task of developing and in-corporating as constraints in their prob-lems robust positive theories of themarket, organizational and human be-havioral phenomena that were importantto the problems.^ This is also the reasonwhy as scientists we cannot successfullyuse a straightforward operations researchapproach to choose accounting proce-dures or accounting standards; we do notknow the necessary positive theories wellenough to predict the effects of alterna-tive choices.

All purposeful actions must (at leastimplicitly) involve positive theory, thatis, a presumption that the chosen actionwill bring about the desired results. How-ever, it is not necessary to presume thatthese positive theories are explicitly con-templated by the agents we study. In fact,as Alchian [1950] long ago pointed out,we need not even assume that agents areengaged in purposeful activity for ourmodels to work. As an extreme case,suppose agents do not learn from obser-vation and randomly choose strategiesand actions. Suppose also that the en-vironment rewards with survival thosewho happen to select strategies that arecloser to optimal and grants extinction tothose who are unlucky enough to choosedominated strategies or actions. In suchan environment, observed behavior andinstitutions will tend toward the optimalbecause those far from it will continuallytend towards extinction. In the lessextreme and more realistic case whereagents learn from empirical observationand engage in purposeful action, we canexpect surviving institutions and prac-tices to be an even better source of infor-mation to the scientist seeking to discoverthe relevant positive theories. Finally,science itself can affect the world. As ourscientific understanding of the world isimproved, our ability to relate actions to

desired outcomes is improved. Pareto[1935, §1785] summarizes the pointquite succinctly:

In the Middle Ages master-masonsbuilt marvelous edifices by rules ofthumb, by empiricism, without the re-motest knowledge of any theory as to theresistance capacities of building mate-rials—merely by trying and trying again,rectifying mistakes as they went along.Now thanks to such theories, modemengineers not only eliminate the lossesincident to the. old mistakes, but erectbuildings that the master-masons andother artisans of past centuries could notpossibly have built. Practice had taughtphysicians certain remedies that wereoftentimes better than those recom-mended by quacks or alchemists. Some-times again they were altogether worth-less. Nowadays chemical theories haveeradicated not all, but a very large num-ber, of those mistakes, and biology hasmade it possible to make better use ofmany substances that chemistry placesat the disposal of medicine. Only a fewyears back, in making cast iron in ablast-fumace it was wiser to follow thedirections of an empiricist than theprescriptions of theory. Today the ironindustry is no longer carried on withoutconsultant chemists and other theorists.The same may be said of the dyeingindustry and of many others.

As a result of the subtle interactions ofthe continual striving by purposefulindividuals and the natural selectionproperties of the environment, extremelycomplicated and sophisticated institu-tions and practices can arise. And, asHayek [1979, pp. 153ff] emphasizes,most of the complex and sophisticatedphenomena that make up human culture(markets and mores are examples) werenever consciously invented by any indi-

^ This conjecture, of course, is a positive theory andcapable of being tested.

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vidual. Indeed, much of human culture isstill not well understood.

The general decision structure deline-ated above also clarifies the criteria foraccepting or rejecting theories. Theoriesare not rejected in a vacuum. If a theorypredicts poorly but still better than thebest available alternative, it will not beabandoned by the decision maker be-cause doing so will reduce his welfare. Asthe old saying goes, "you can only beat atheory with another theory." The choiceamong competing theories will be basedon which is expected to yield the highestvalue of the objective function when usedfor decision making. Single observationsinconsistent with a theory will not neces-sarily bring rejection, nor is there a"natural" significance level such as 5%that brings rejection. Thus, care must betaken in interpreting the significancetests often used by scientists who are notin a decision maldng capacity and there-fore do not have a well-defined objectivefunction to use for deciding amongcontending theories.

How does one go about developing apositive theory of accounting, one thatwill ultimately aid in normative choices?I start by focusing on the relationshipbetween organizational form and ac-counting practice—to recognize formallythat accounting is a basic part of thestructure of every organization. I thendiscuss the emerging research on aneconomic theory of organization.

III. ACCOUNTING ANDORGANIZATIONAL FORM

Accountants have long recognized theimportance accounting has played in thestewardship or control of organizations,and this is consistent with the notion thataccounting is a basic part of organiza-tional structure and that accountingpractice and organizational form are

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related. Accounting practices clearly dif-fer across organizations—profit vs. non-profit, for example. Frequently non-profits do not record capital assets ontheir balance sheets and do not calculatedepreciatioa Fund accounting, of course,is very different from the usual for-profitsystem. Satisfactory explanations ofthese differences do not exist.* But this isnot surprising, considering that socialscientists have not generated satisfactoryexplanations for why nonprofit organi-zations exist and why they seem todominate some activities like educationand religion and not others like manufac-turing.* Taxes are not sufiicient to explaintheir existence, because nonprofits existedlong before income taxes became impor-tant. Moreover, many other types oforganizational forms exist and tend to berelated to the type of production activi-ties the organization undertakes. Pub-licly held or open corporations aredominant in large, complex, capital-intensive activities like manufacturing.Partnerships are dominant in sensitiveservice activities like law and publicaccounting, and nonprofits in religion,education, and classical music.

Moreover, within broad organiza-tional categories, specific organizationsdiffer along many dimensions such asperformance evaluation, compensation,budgeting, costing, pricing, capital struc-ture, distribution, and sales practices.There is little scientific understandingabout why organizations of a givengeneral type differ along these dimen-sions. And if accounting practices aresignificantly affected by an organization'sstructure, then without a fundamentalunderstanding of why organizations dif-

* See Zimmerman [1977].' See Hansmann [1980, 1981] and Fama and Jensen

[1982,1983a, 1983b]forseveralrecentattempts to under-stand where nonprofit organizations survive and why.


fer we have no fundamental understand-ing about why accounting policies differacross organizations.*

Consider, for example, the use of profitcenters vs. cost centers as the basis fordefining divisions of an organization.Although economists and accountantshave analyzed both of these organiza-tional devices, no satisfactory theoryexists that will predict when an activitywithin an organization will be organizedas a cost center and when as a profitcenter.^ Though the accounting proce-dures employed for each type of organi-zation are well known, the relation of theaccounting procedures to the develop-ment of the firm's organization is worthyof research. In addition, there is evidencein Chandler's [1962, pp. 61,145 ff ] workthat the organizational innovations thatled to the large, integrated, multi-divi-sional American firms in the early 1900'swere accompanied by substantial innova-tions in accounting practices.

We are almost as ignorant regardingwhy financial reporting practices differamong organizations. Again, to theextent that little theory exists to explainwhy organizations differ in their financialreporting practices and what the effectsof those different practices are, littlescientific basis exists to advise manage-ment, the FASB, or the SEC on how toimprove such practices through changesin accounting standards or regulation.®This brings me back to my main topic,the emerging research in economics thatis related to organizations.

IV. THE IMPENDING REVOLUTION INORGANIZATION THEORY

I believe a revolution will take placeover the next decade or two in our knowl-edge about organizations. This processwill involve accounting researchers aswell as economists and other socialscientists. Accounting theory has bene-

fited greatly from advances in our knowl-edge of finance and financial marketsover the last two decades—advances inwhich accounting researchers haveplayed an important role. I foresee ad-vances in organization theory which willhave an even larger impact on accountingresearch, and the effects will extend be-yond accounting to finance, economics,and management education and practice.

The last decade has been marked by agrowing interest in organizations withinthe economics profession. The work ofseveral dozen scholars comes to mind,and I am sure there is much work un-known to me.^ The science of organi-zations is still in its infancy, but thefoundation for a powerful theory oforganizations is being put into place. In aparallel development there is a growingbody of accounting literature addressingrelated problems that generally goesunder the label of positive research inaccounting.^" The existence of empirical

* For a number of studies that address these issues seeWatts [1977], Watts and Zimmerman [1978, 1979],Leftwich [1983], and Holthausen [1981].

' This means, incidentally, that as scientists we havelittle advice to offer management regarding whether costor profit centers would be best to use in any given activity.

* Understanding why the FASB and the SEC behaveas they do and their effects on accounting requires apositive theory of the political process—another difficultarea which is experiencing great scientific progress. Theresearch on financial reporting evidences an under-standing of this and I shall ignore these political/regula-tory issues here.

« See, for example, Williamson [1964, 1975, 1979,1981], Arrow [1963, 1974], Alchian [1950, 1969, 1981],Alchian and Demsetz [1972], Pejovich [1969], Furubotnand Pejovich [1973], Jensen and Meckling [1976, 1979],Lazear [1979], Lazear and Rosen [1981], Klein, Craw-ford and Alchian [1978], Harris and Raviv [1978],Harris, Kriebel and Raviv [1981], Fama and Jensen[1982a, 1982b, 1983], Fama [1980], Smith and Warner[1979], Chandler [1962, 1977], Chandler and Daems[1980], Daems [1978], Hansmann [1980,1981 ], Demsetz[1982], Reagan and Stulz [1982], Marvel [1982], Meck-ling [1976], and Mayers and Smith [1981,1982a, 1982b].

'" See, for example, Benston [1963, 1975a, 1975b,1979-80], Watts [1977, 1981], Watts and Zimmerman[1978, 1979, 1982a], Hagerman and Zmijewski [1979],

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regularities between the choice of ac-counting procedures and organizationalcharacteristics such as size and capitalstructur;e is beginning to be documentedin that literature. A healthy and prosper-ing journal, the Journal of Accounting andEconomics, has been founded by mycolleagues Ross Watts and Jerold Zim-merman to further encourage the devel-opment of a positive accounting liter-ature.

A. The Dimensions of OrganizationsBill Meckling, my colleague and Dean,

and I have spent a half dozen yearsinvestigating the application of the princi-ples of economics to the analysis oforganizations and in the process havedeveloped a new course entitled Coordi-nation and Control in Organizations.One of the frustrating aspects of thateffort has been the difficulty associatedwith developing an understanding anddefinition of the relevant dimensions touse in characterizing the structure of anorganization. Organizations are complexsystems. If we are to make progress inunderstanding them we must order thatcomplexity. We must find and articulatea set of organizational characteristicswhich can explain why various organiza-tions function as they do.

In developing our coordination andcontrol course, we have arrived at athree-part taxonomy to characterize or-ganizations:

1. the performance measurement andevaluation system,

2. the reward and punishment system,3. the system for partitioning and

assigning decision rights amongparticipants in the organization.

I do not have space here to discuss theimportance of this classification scheme,but notice that the accounting and con-trol system plays a major role in all three

dimensions. Viewing the organizationfrom this perspective helps provide struc-ture to the notion of the stewardship roleof accounting in the organization. Fur-thermore, differences in these three di-mensions across organizations are highlylikely to result in differences in account-ing systems. This also indicates thataccounting is an integral part of thestructure of every organization and that athorough understanding of organiza-tional forces is important to a theory ofaccounting.

In addition to the requirement for abetter understanding of the relevant di-mensions of organizations, progress inthe development of a theory of organiza-tions wA\ also be aided by understandingwhy economics has not already yieldedsuch a theory.

B. Limitations of the Economic Theoryof the Firm

Unfortunately, the vast literature ofeconomics that falls under the label of"Theory of the Firm" is not a positivetheory of the firm, but rather a theory ofmarkets. The organization or firm in thattheory is little more than a black box thatbehaves in a value- or profit-maximizingway. In most economic analyses, the firmis modeled as an entrepreneur whomaximizes profits in an environment inwhich all contracts are perfectly andcostlessly enforced. In this firm there areno "people" problems or informationproblems, and as a result the researchbased on this model has no implications

Leftwich, Watts and Zimmerman [1981], DeAngelo[1981a, 1981b], Collins, RozefT and Dhaliwal [1981],Holthausen [1981], Zmijewski and Hagerman [1981],Dhaliwal [1980], Lilien and Pastena [1982], Bowen,Noreen and Lacey [1981], Healy [1982], Dhaliwal,Salamon and Smith [1982], Jarrell [1979], and Lys[1982]. Useful reviews of this literature are provided byHolthausen and Leftwich [1982], Zimmerman [1980],and Watts and Zimmerman [1982b].


for how organizations are structured orhow they function internally. The firm is,in effect, assumed to be an elementarycomponent of the analysis even though infact it is an exceedingly complex sub-system. This is not necessarily wrong.When it is appropriate for a scientist totreat a complex subsystem as an ele-mentary component is a subtle anddifficult issue. Herb Simon's article on"The Architecture of Complexity" con-tains an excellent analysis of the issue.As Simon [1962, p. 469] poses theproblem:

. . . In most systems in nature, it issomewhat arbitrary as to where we leaveoff the partitioning, and what subsystemswe take as elementary. Physics makesmuch use of the concept of "elementaryparticle" although particles have a dis-concerting tendency not to remain ele-mentary very long. Only a couple ofgenerations ago, the atoms themselveswere elementary particles; today, to thenuclear physicist they are complex sys-tems. For certain purposes of astronomy,whole stars, or even galaxies, can beregarded as elementary subsystems. Inone kind of biological research, a cellmay be treated as an elementary subsys-tem; in another, a protein molecule; mstill another, an amino acid residue.

Just as astronomers can usefully ab-stract from the complexities inside a staror a galaxy for certain purposes, theclassical economic notion of the firm hasusefully abstracted from the internalcomplexities of organizations. It hasyielded a robust theory of markets that isof great value. However, precisely be-cause the definition of the firm abstractsfrom most of the real problems andcomplexities of organizations, it providesno insights to the construction of a theoryof organizations. The concepts of mar-ginal analysis, competition, opportunitycost, and equilibrium that have been

useful in the development of a theory ofmarkets will also be valuable in thedevelopment of a theory of organiza-tions. They are not, however, enough toaccomplish the job. This raises the ques-tion of what we use to replace the blackbox view of the firm.

V. THE NEXUS OF CONTRACTS VIEW

OF ORGANIZATIONS

I believe it is productive to define anorganization as a legal entity that servesas a nexus ̂ ̂ for a complex set of contracts(written and unwritten) among disparateindividuals (see Jensen and Meckling[1976, pp. 310ff ]). The multilateral con-tracts between agents that characterizemarket relations are supplanted within anorganization by a system in which therelationships among the cooperatingagents are largely effected through uni-lateral contracts with the legal entity thatserves as the contracting nexus. Thesecontracts specify the rules of the gamewithin the organization, including thethree critical dimensions outlined above:the performance evaluation system, thereward system, and the assignment ofdecision rights. This view of organiza-tions focuses attention on the natureof the contractual relations amongthe agents who come together in anorganization—including suppliers oflabor, capital, raw materials, riskbearingservices, and customers.

The nexus of contracts view helps us tosee organizations in a way that can pro-vide useful insights. It leads to inquiryabout why certain contractual relationsarise and how those relations respond tochanges in the environment. For example,it leads us to see the shopping center as anorganizational form that is an interestingalternative to a collection of indepen-

' ' "A connection, tie or link between individuals of agroup, members of a series, etc." Webster's [1978].

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dently owned stores grouped together ina shopping district or as an alternative toa large department store where there is noindependent ownership of individual de-partments. The department store is anorganizational device that internalizesthe externalities generated by locatingcertain types and qualities of storestogether and providing certain servicescentrally—so too is a supermarket. Onthe other hand, as such organizationsgrow in size, shirking problems growlarger and so do other problems as-sociated with providing departmentmanagers, buyers, etc. with the correctincentives. The shopping center withcommon ownership of buildings andparking facilities coupled with contrac-tual procedures that control the types ofstores in the center, their quality, and soon, can also internalize many of theexternalities of pure independent owner-ship. Some of the incentive problems aresolved in the shopping center structure bymaintaining independent ownership ofthe individual stores and charging forparticipation in the organization througha fixed fee rental plus a percentage ofrevenues or profits.

Although this is not the place to pursueit, it is easy to see how comparisons ofsuch organizational forms lead to ques-tions regarding the factors that givecompetitive advantages to each of thesethree organizational types (shopping cen-ters, department stores, and indepen-dently owned specialty stores) at varioustimes and at various locations. Suchquestions are relevant because we knowall three types of organizations continueto compete and survive. Close examina-tion should also reveal differences inaccounting systems in these organiza-tions (differences that arise from theproblems and opportunities peculiar toeach of them) and the role accountingplays in permitting these organizations to

survive. Understanding such differencesand why they arise will add another set ofelements to the theory of accounting.

The nexus of contracts view of organi-zations also helps to dispel the tendencyto treat organizations as if they werepersons. Organizations do not havepreferences, and they do not choose inthe conscious and rational sense that weattribute to people. Anyone who hasserved on committees understands thisfact. Usually no single person on acommittee has the power to choose theoutcome, and the choices that result fromcommittee processes seldom resembleanything like the reasoned choice of asingle individual. The voting paradoxexamined at length in the political scienceliterature is an example of this point. Theold description of the camel as a "horsedesigned by a committee" also capturesthe point.

The behavior of the organization is theequilibrium behavior of a complex con-tractual system made up of maximizingagents with diverse and conflicting ob-jectives. In this sense, the behavior ofthe organization is like the equilibriumbehavior of a market. We do not oftencharacterize the steel market or thewheat market as having preferencesand motives or making choices like anindividual, but this mistake is commonlymade about General Motors, Peat, Mar-wick, Mitchell & Co., and so on. Con-struction of a theory of organizationsinvolves creating a theory that describesthe equilibrium behavior of these com-plex contractual systems where the indi-vidual agent is the elementary unit ofanalysis. ̂ ^

'^ See Meckling [1976] for a discussion of alternativemodels of man as the elementary unit of analysis.Sociobiologists, however, find it useful for analysis ofsome questions to view the gene as the elementarymaximizing entity. See Hirshleifer [1978] and Dawkins[1976] and the references therein for discussions of thisalternative model.


As Simon emphasizes, the definition ofthe elementary unit of analysis in scienceis not a matter of "right" or "wrong" butrather one of usefulness. Whether onechooses the "black box" or "nexus ofcontracts" definition of an organizationdepends on the question at hand. Somequestions, like how outputs of a firm orindustry respond to price changes, aremore productively addressed with theformer. Other questions, such as thoseinvolving organizational problems likethe choice of accounting practices, aremore productively addressed in the nexusof contracts perspective. However, whenusing the black box approach it is im-portant to remember that it is a con-venient abstraction that is appropriateonly for analysis of some questions. Thedanger in its use arises because it furtherencourages the tendency to personalizeorganizations by attributing motives andpreferences to what is in fact a complexequilibrium system. Such personalizationof organizations easily leads to uncriticalapplication of the black box approach toquestions it cannot handle.

VI. SOME RECENT RESULTS ON CONTROL

Eugene Fama and I have been workingfor several years to understand the char-acteristics that give survival value todifferent organizational forms. One ofour concerns has been to understand thefactors that give survival value to organi-zations like large public corporationscharacterized by separation of "owner-ship and control," or, more precisely,separation of the decision managementand residual riskbearing functions. Schol-ars from Adam Smith [1776] to Berle andMeans [1932] have pointed out theinconsistency of interests between man-agers and outside stockholders and haveemphasized the costs these conflictsgenerate. Yet, even though other organi-zational forms such as proprietorships.

small partnerships, and closed corpora-tions compete with corporations and doso without the handicap of the costs ofseparation of ownership and control, theevidence is clear: in the production of awide range of activities, the corporationcontinues to win the competition forsurvival.

In fact, the large, publicly-held cor-poration is not unique in its separationof "ownership and control." Separationof decision management and residualriskbearing characterizes many organi-zational forms, for example, financialmutuals and large professional partner-ships. Nonprofit organizations whichhave no alienable residual claims consti-tute the extreme form of separation ofownership from control.

Fama and I conclude that separationof decision management (the initiationand implementation of decisions) fromdecision control (the ratification andmonitoring of decisions) in the organi-zation is the major device that limits thecosts due to separation of "ownershipand control." The evidence indicates thatopen corporations, financial mutuals,large partnerships, and nonprofit organi-zations are all characterized by separa-tion of decision management anddecision control functions. Moreover,all these organizations use a commondevice—boards of directors, trustees, ormanaging partners—to accomplish suchseparation at the top level of the organi-zation. These boards have the rights toratify and monitor the decisions that areinitiated and implemented by top-levelmanagers. In addition, they always havethe power to hire, fire, and set the com-pensation of the top-level managers. Thistop-level separation of decision manage-ment from decision control and the sepa-ration and diffusion of decision manage-ment and decision control rights amongagents throughout lower levels of the

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organization are the contractual re-sponses that limit the costs of theseparation of "ownership and control"and therefore foster survival of these or-ganizations (Fama and Jensen [1983b]).

Watts and Zimmerman have pointedout that our separation propositionmirrors the standards recommended inthe auditing and control literature. Stett-ler's [1977] auditing text, for example,urges that operations responsibility beseparated from accounting responsibilityby vesting the two functions in differentpeople. ̂ ^ In handling cash, the recom-mendation is to separate the responsi-bility for the record-keeping functionfrom the person who receives the cash,and similarly for authorizing and drawingchecks in the payout process. Thesewidely practiced principles have evolvedfrom long experience with conflicts ofinterest and evidently have survival value.Since Fama and I derived our proposi-tions about control in a quite differentcontext, these common practices forhandling cash, accounts payable, and soon, are encouraging evidence consistentwith our thesis. It is exciting that, ap-propriately generalized, some of the sameprinciples that apply to the conflict ofinterest problem in the handling of cashalso apply to the conflict of interestsbetween managers and stockholders andboards of directors of corporations,financial mutuals, large partnerships, andeven nonprofit organizations. It giveshope that the next decade will witnesssuccess in the construction of a rich andgeneral theory of control.

VII. METHODOLOGICAL ISSUES

Whether the potential to develop ascience of organizations will be exploiteddepends, of course, on many factors. Iwould like to discuss some importantmethodological issues: (1) the impor-tance of tautologies and definitions, (2)

the difliculty but desirability of dealingwith qualitative institutional evidence,and (3) the role of mathematics.

A. The Importance of TautologiesIn the language of science, a tautology

is a statement that is true by definitionand can never be refuted by evidence.^*Therefore, it is not an hypothesis or atheory. A definition declares that anewly-introduced symbol means the sameas another combination of symbolswhose meaning is already known; it,therefore, also cannot be refuted byevidence.

The choice of tautologies or defini-tions has a large impact on the success orfailure of research efforts—a fact thatoften goes unrecognized. Discussion ofnew research efforts often meets withresistance on the grounds that the effortis purely definitional, or the propositionsare tautological and devoid of empiricalcontent. Yet thorough and careful atten-tion to definitions and tautologies is oftenextremely productive in the early stagesof research, especially if the research is aradical departure from the past. On theother hand, it is also common to observetalented manpower devoted to sterileresearch on toy problems or characteriza-tions of problems that bear little relationto the world and the rich variety ofoptions that people face. The sterility ofthis research can often be traced to thechoice of definitions and tautologies thatfocus the effort. Unfortunately, there isno obvious criterion we can apply to helpus select more productive rather than lessproductive tautologies or definitions.

'•* "In general, no one department should be re-sponsible for handling all phases of a transaction, and ifpossible, the division of responsibility should keepoperations and custodianship separate from account-ing." Stettler [1977, p. 56].

'* Philosophers have a precise definition of tautology.I use the term here more loosely and more in accord withits use in the social sciences.


Perhaps such choices will remain one ofthe "artistic" or creative parts of science.

Alfred Whitehead and BertrandRussell [1910, pp. 11 ff] emphasize theimportance of the choice of definitions:

In spite of the fact that definitions aretheoretically superfluous, it is neverthe-less true that they often convey moreimportant information than is containedin the propositions in which they areused. This arises from two causes. First,a definition usually implies that thedefiniens [the meaning in terms of thecombination of already known symbols]is worthy of careful consideration. Hencethe collection of definitions embodiesour choice of subjects and our judgmentas to what is most important. Secondly,when what is defined is (as often occurs)something already familiar, such ascardinal or or4inal numbers, the defini-tion contains an analysis of a commonidea, and may therefore express a notableadvance. Cantor's definition of the con-tinuum illustrates this: his definitionamounts to the statement that what he isdefining is the object which has theproperties commonly associated with theword "continuum," though what pre-cisely constitutes these properties hadnot before been known. In such cases, adefinition is a "making definite"; itgives definiteness to an idea which hadpreviously been more or less vague.

For these reasons, it will be found, inwhat follows, that the definitions arewhat is most important, and what mostdeserves the reader's prolonged atten-tion.

The mathematical biologist, A. J. Lotka[1956, pp. 3f ], provides another examplewhen he characterizes the enunciation ofthe survival of the fittest as one of thefundamental advances of science. It is atautology because the fit is defined to bethat which survives. The Coase Theorem[1960] is another important tautologythat has helped us to see the importance

of transactions costs in a fundamentallydifferent fashion. (See Demsetz [1982,ch. 2]). The proposition that consumersmake choices so as to maximize theirutility is also a tautology that has proveduseful in understanding human behaviorand markets. Another tautology thataccountants will agree is important is theproposition that assets equal liabilitiesplus equity—at least as long as I'm notdoing the arithmetic. The usefulness andpower of double-entry bookkeeping istestified to by its survival since at least the15th century and its continuing wide-spread use. Viewing double-entry book-keeping this way leaves me believing thatwe still do not thoroughly understandwhy it is a powerful organizing device. Iam so used to thinking of assets and theclaims on them, equities and liabilities,as a way of organizing thoughts aboutcompanies that it is hard to conceive ofalternatives.^^

The word tautology has strong pejora-tive overtones in our profession—to beaccused of stating a tautology is practi-cally the highest of professional insults.Therefore, I hasten to add that while atautology of one form or another lies atthe heart of all useful theory, this does notmean that such theory has no refutable,i.e., positive, implications. Darwin andthe biologists who followed him as wellas economists using the Coase Theoremand utility maximization have thoroughlydemonstrated the empirical content oftheir theories.

The manner in which we use tautolo-gies to develop positive theories is closelyrelated to the nature of the scientificprocess itself. The process involves theuse of the definitions and the underlyingtautology (such as the survival of the

" I am left with questions; for example why don't weorganize our thoughts about the family through thedouble-entry tautology? Perhaps someday these issueswill be better understood.

Jensen 331

fittest) and a subset of the available dataon surviving and extinct species to de-velop propositions about the importantaspects of the environment and theirrelation to traits contributing to survival.When successful, the result is a theorythat is consistent with the utilized data.This theory can then be tested with as yetunused data. In addition, the theoreticalstructure can be manipulated to deriveadditional nonobvious propositionswhich can also be confronted with newor previously unused data to providetests. When the data is substantiallyinconsistent with the predictions, thetheory is revised or replaced and theprocess continues. This is a continuingprocess, of course, and takes place overa series of studies and papers.

Finally, note how Whitehead andRussell's emphasis on the importance ofdefinitions applies to the economic notionof the firm. Defining the firm as a blackbox diverts attention away from what isgoing on within the firm. The nexus ofcontracts definition of organizations, onthe other hand, focuses attention on theproblems that the contracts are intendedto solve, i.e., on how things get donewithin the organization. Whether thenexus of contracts view will be as produc-tive as I think it will be is itself an empiri-cal question. However, the relativelyrecent development of the positive theoryof agency lends encouragement to theview that the nexus of contracts approachwill be productive.

B. Two Useful Tautologies—AgencyCosts are Minimized and Survival of theFittest

The positive theory of agency alsoderives from several definitions and asimple tautology. Cooperative behaviorbetween human beings is viewed as acontracting problem among self-inter-ested individuals with divergent interests.

Agency costs are defined as the sum of thecosts of structuring, bonding, and moni-toring contracts between agents. Agencycosts also include the costs stemmingfrom the fact that it doesn't pay to en-force all contracts perfectly. Recog-nizing that one or more of the contractingparties can capture the benefits fromreducing the agency costs in any relation-ship provides the analytical device, thetautology, that yields implications for theforms of the contracts that evolve ̂ ^—maximizing agents minimize the agencycosts in any contracting relationship(Jensen and Meckling [1976]). Noticehow conveniently this dovetails with thenotion of organizations as a nexus ofcontracts; its application there impliesthat the organizational form, its con-tracts, will be those that minimize theagency costs.

Adding two more elements, (1) thenotion that competition is a generalphenomenon that takes place over manydimensions, including organizationalform, and (2) the survival of the fittesttautology,^' completes most of the majorbuilding blocks of the analytical frame-work for creating a theory of organiza-tions. The view is one of organizationscompeting with each other to deliver theactivities demanded by customers. Thoseorganizations survive that are able todeliver the activities or products at thelowest price while covering costs. Under-standing the survival process involvesunderstanding how the contracts of par-

'* For some interesting applications of this approachsee Smith and Warner [1979] who use it to explaincovenants in bond indentures, Mayers and Smith [1981,1982a, 1982b], who examine contracting and organiza-tional practices in the insurance industry, and Leftwich[1983], who examines the private contractual specifica-tion of accounting procedures. Holthausen [1981] usesthe approach to derive hypotheses about managementdecisions to change depreciation methods. His testsindicate the data are not consistent with the hypotheses.

'^ Alchian [1950] long ago argued for the use of thenatural-selection principle in economic analysis.


ticular organizations achieve low costcontrol of agency problems and how theycombine with the production technologyof an activity to enable the organizationto survive (Fama and Jensen [1982a,1983a, 1983b]).

C. The Nature of Evidence

Since a theory of organizations is inessence a special case of a general theoryof contracting, it is likely that someconfusion and disagreement will arise inthe profession over the nature of evi-dence bearing on the theory. Indeed, thisdisagreement is already becoming evidentin the research on organizations and inpositive research in accounting.

Economists, financial economists, ac-counting researchers and behavioral sci-entists are well indoctrinated in themethodology associated with the use ofquantitative evidence in the testing oftheories. We have been fortunate, forexample, that the theory of efficient mar-kets yields direct predictions about thecharacteristics of the probability distri-butions of asset price changes and re-turns—predictions for which a richvariety of data and statistical theory areconveniently available for testing pur-poses. However, many important predic-tions of the research on positive organi-zation theory and positive accountingtheory will be characterizations of thecontracting relations, and much of thebest evidence on these propositions willbe qualitative and institutional evidence,that is, evidence on the forms of thecontracts, their provisions, and on otherorganizational and accounting practices.By its nature, much of this institutionalevidence cannot be summarized by meas-ures using real numbers. We simplydo not know how to aggregate such evi-dence, nor can we calculate formalmeasures of central tendency and stan-dard errors of estimate. This means, of

course, that regression equations cannotbe estimated, and this will not bringcomfort to those empiricists who clutchregression equations to their breastslike security blankets. Statisticians andeconometricians are likely to react be-cause it violates a long and venerabletradition of formal testing.

Whenever feasible, of course, it isdesirable to obtain quantitative predic-tions of a form amenable to the usualtesting procedures. However, since thetheory is aimed at explaining the contractstructures and practices of organizations,it seems unwise to ignore evidence onsuch structures in testing the theory. Itseems especially unwise in the earlystages of development because any theorythat is likely to be useful and worthy ofdetailed consideration should not bevastly inconsistent with the readily avail-able institutional evidence. Not all suchtheories will, however, be acceptable andherein lies a serious inference problem.The fact is that a well developed theoryof inference for dealing with quantitativedata exists and it is of great value. Such atheory is not nearly as well developed fordealing with the qualitative institutionaldata that characterize the organizationalfield, and therefore the likelihood ofmisuse of data and incorrect inferences ishigher.

Nonparametric statistics provide onlylimited help in dealing with institutionalevidence because these procedures gen-erally presume independence in sampleobservations—a condition seldom satis-fied. In addition, it is often difficult toknow what procedures were followed inselecting a sample of institutional evi-dence, and this raises serious questionsabout the existence of selection bias andtherefore about the inferences to be madefrom the evidence. Finally, because insti-tutional evidence consists of non-com-mensurable items we do not know how to

Jensen 333

formally weight the individual pieces ofevidence; they cannot be simply countedor added up. Yet this does not mean theobservations are not evidence, and mostpeople intuitively understand this whenit comes to the issues considered in acriminal trial. With the help of statisti-cians and philosophers, perhaps someprogress will be made in resolving theseinference problems.

Meanwhile, it is unwise to ignore im-portant institutional evidence while pay-ing great attention to unimportantquantitative evidence simply because itsdimensions are more familiar. The prac-tice of using pejorative labels such as"casual," "anecdotal," or "ad hoc" todescribe such institutional or qualitativeevidence is counterproductive to theresearch process. Such labels suggestuncaring or sloppy methods or unimpor-tant evidence. "Readily available" or"institutional" evidence are reasonablesubstitutes for these emotion-ladenterms. "Incomplete," or "inappropriate"evidence are reasonable descriptive labelsto use when the researcher's methods arein fact uncaring or sloppy. Not all insti-tutional evidence is readily available;much of it requires a great deal of effortto gather. On the other hand, stock pricedata, accounting data and national in-come data are readily available to thescientist but they are not given pejorativelabels such as "casual." For severalcarefully executed and useful studiesusing institutional evidence, I recom-mend the study of the covenants in bondindentures by Smith and Warner [1979],the Mayers and Smith [1981, 1982a,1982b] work on organizations and con-tractual practices in the insurance indus-try, the study of the market for account-ing theories by Watts and Zimmerman[1979], and the study of private specifi-cation of accounting procedures byLeftwich [1983].

D. The Role of Mathematics

Mathematics is a very useful language,but not universally so. It is often useful inthe derivation of non-obvious implica-tions that are difficult to develop by othertechniques. The propositions of portfoliotheory and asset pricing are examples.The unaided human mind and the Englishlanguage are not well suited to handlingthe complexities of the notion of a co-variance matrix and solutions to sets ofsimultaneous equations. Without thehelp of the language of mathematics,the insights of portfolio theory and assetpricing along with many others wouldlikely remain unknown.

Sometimes, however, the use of mathe-matics is counterproductive in the re-search process. This is especially true indealing with new and uncharted areassuch as organization theory and ac-counting theory. As implied by theprevious discussion of definitions andtautologies, a great deal of work has tobe done in a new area of analysis thatrepresents a radical departure from cur-rent knowledge before the dimensionalityof the problem and the major variablescan be defined. Mathematics seems to beuseless for solving these problems. Myimpression is that attempts to use it atsuch an early stage in the development ofan area are often counterproductive be-cause authors are led to assume theproblem away or to define sterile "toy"problems that are mathematically tract-able.

Unfortunately, there exists in the pro-fession an unwarranted bias towards theuse of mathematics even in situationswhere it is unproductive or useless. Onemanifestation of this is the common useof the terms "rigorous" or "analytical"or even "theoretical" as identical with"mathematical." None of these links is,of course, correct. Mathematical is not


the same as rigorous, nor is it the same asanalytical or theoretical. Propositionscan be logically rigorous without beingmathematical, and analysis does nothave to take the form of symbols andequations. The English sentence andparagraph will do quite well for manyanalytical purposes. In addition, the useof mathematics does not prevent thecommission of errors—even egregiousones.

There will always be some people whothink and produce better in one languagethan another. And there will be problemsand problem areas where one language oranalytical approach is more productivethan another. Nevertheless, some re-searchers take the attitude that analysis isworthwhile and important only if ac-complished through the language ofmathematics. Others are antagonistictoward analysis that uses mathematics.Hopefully, as the profession matures,more tolerance, understanding, and con-sideration of these issues will prevail. Asour knowledge of organizations andaccounting theory grows I expect to seeincreased productive use of mathematics.

VIII. THE TWO AGENCY LITERATURES

Since the original papers by Spenceand Zeckhauser [1971] and Ross [1973],substantial attention has been given tothe development of the theory of agency.Interestingly, that development has re-sulted in two almost entirely separate andvaluable literatures that nominally ad-dress the same problem. However, thetwo literatures differ in many respects,and they reference each other less thanone might expect given the closeness oftheir topics. Being actively involved inone of these efforts and a neophyte in theother, I am not the best person to providean unbiased comparison of them, butsome discussion seems appropriate atthis point.

Earlier, I briefly discussed one of theagency literatures—what I have labeledthe "positive theory of agency." Theother literature has acqtiired the label"principal-agent."^* Both literatures ad-dress the contracting problem betweenself-interested maximizing parties andboth use the same agency cost minimiz-ing tautology (although not necessarilystated in that form). They differ, how-ever, in many respects. The principal-agent literature is generally mathematicaland non-empirically oriented, while thepositive agency literature is generallynon-mathematical and empiricallyoriented (although neither literature isentirely so).

The principal-agent literature has gen-erally concentrated on modeling theeffects of three factors on contractsbetween parties interacting in the hier-archical fashion suggested by the termprincipal-agent: (1) the structure of thepreferences of the parties to the contracts,(2) the nature of uncertainty, and (3) theinformational structure in the environ-ment. Attention is generally focused onrisk sharing and the form of the optimalcontract between principal and agent,and on welfare comparisons of the equi-librium contracting solutions in the pres-ence of information costs vis-a-vis thesolutions in the absence of such costs.

The positive agency literature hasgenerally concentrated on modeling theeffects of additional aspects of the con-tracting environment and the technologyof monitoring and bonding on the formof the contracts and organizations thatsurvive. Capital intensity, degree of spe-

" Some representative but far from exhaustive refer-ences are Spence and Zeckhauser [1971], Ross [1973,1974], Raviv [1979], Hards and Raviv [1978], Mirrlees[1976], Harris and Townsend [1981],Townsend [1979],Holmstrom [1979], and Shavell [1979]. Demski andKreps [forthcoming] review the accounting-relatedliterature in this area.

Jensen 335

cialization of assets, information costs,capital markets, and internal and externallabor markets are examples of factors inthe contracting environment that interactwith the costs of various monitoring andbonding practices to determine the con-tractual forms. ̂ ^

Each of the agency literatures has itsstrong and weak points, and on occasiontension has surfaced between them. Insome sense the reasons are understand-able. Part is due to the "tyranny offormalism" that develops when mathe-matically inclined scholars take the atti-tude that if the analytical language is notmathematics, it isn't rigorous, and if aproblem cannot be solved with the use ofmathematics, the effort should be aban-doned. Part is due to the belief that thelack of the use of mathematics in thepositive agency literature results in expost facto theorizing that assures thehypotheses will not be rejected. Part isalso due to the problems associated withthe use of qualitative and institutionalevidence, discussed earlier.

Though much of the principal-agentliterature seems to be produced in thenormative mode, most of it can be inter-preted in a positive fashion. However,some believe that so little is put into thecurrent principal-agent models that thereis little hope of producing results that willexplain much of the rich variety of ob-served contracting practices. Tractabilityproblems seem to limit the richness of theinput to the principal-agent models,especially when it comes to analyzing theeffects of markets on the contractingprocess—for example, capital and labormarkets and the market for control. Italso seems difficult to analyze within theprincipal-agent models the effects ofcomplex eqtiilibrium systems in the con-tracting milieu, for example, mutualmonitoring systems like the coUegialsystem so familiar to academics.

The issue boils down to an empiricalquestion regarding how useful the prefer-ence, stochastic structure, and informa-tion structure variables are in explainingobserved contracting practices. The posi-tive agency literature proceeds on theimplicit assumption that the variablesemphasized in the principal-agent litera-ture are relatively unimportant inunderstanding the observed phenomenonwhen compared with richer specificationsof information costs, other aspects of theenvironment, and the monitoring andbonding technology.

On the other hand, the methods of thepositive agency literature justifiably seemunconstrained and often perilously closeto tautological to some. In part thisarises from a misunderstanding by someof the nature of the scientific process—the manner irt which we use tautologiesto develop positive theories. At the riskof oversimplifying, the ideal processproceeds by using the agency definitionsand the cost-minimizing tautology de-scribed earlier and a subset of the ob-served contract structures to developpropositions about the important aspectsof the environment and the monitoringand bonding technology—that is, toderive a theory that is consistent withthose contracts. If successful, that effortprovides a structure that can be manipu-lated to derive additional non-obviouspositive propositions, i.e., hypotheses.Confronting these propositions with pre-viously unknown or unused data pro-vides a test of the theory. If the data aresubstantially inconsistent with the predic-tions, the theory is then revised or re-placed with a new alternative and the

'''See, for example, Jensen and Meckling [1976],Myers [1977], Smith and Warner [1979], Fama [1980],Holthausen [1981], Mikkelson [1981], Leftwich [1981],1983], Mayers and Smith [1981, 1982], Watts and Zim-merman [1982a, 1982b], and Fama and Jensen [1982a,1983a, 1983b].


process continues. This is the scientificprocess. In the initial stages we shouldtake care to avoid requiring researchersto accomplish all this in a single study orpaper—an undesirable requirement fromthe standpoint of the progress of science.It is important as colleagues, referees,and editors to avoid applying standardsto individual papers that are appropri-ately applied only to the scientific processas a whole.

On the other hand, it is appropriate tobe suspicious of results obtained from"too much" fishing in the data—in-cluding the institutional data—althoughit is often difficult to tell how much of thathas taken place. The appropriate re-sponse is to treat the results of earlystudies as more like a set of relativelyuntested hypotheses than a well-testedand surving theory.

As a result of the continued gradualdevelopment of our empirical and con-ceptual knowledge, I expect to see the

two agency literatures become closer,partly because the intellectual effortsdevoted by both groups will result in aclearer understanding of the definitionsof the important concepts and the rele-vant dimensions upon which to order thecomplexity of the world. Mathematicswill then be of great help in the generationof non-obvious testable propositions andas a language for use in communicatingthe important aspects of the theoreticalstructure.

In the end, competition in research is asimportant to innovation and progress ascompetition in the product markets.Scholars will make their own judgmentsof what are currently useful results andwhere the productive and exciting re-search approaches and opportunities are.I have little doubt that with the passageof time, the "fit" (that is, the productiveand useful results and approaches) will"survive."

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