The corporation as an organizational form is an enormously productive social invention. Partly because of its success it is under increasing attack f… - William H. Meckling

This paper analyzes the relations between knowledge, control and organizational structure both in the market system as a whole and in private organizations. Limitations on the mental capacity of the human mind and the costs of producing and transferring knowledge means that knowledge relevant to all decisions can never be collected in the mind of a single individual or a small body of experts. This means that if the knowledge valuable to a particular decision is to be used in making that decision, there must be a system for partitioning out decision rights to individuals who already have the relevant knowledge and abilities or who can acquire or produce them at the lowest cost. Self interest on the part of individual decision-makers means a control system is required to motivate individuals with the decision rights and the relevant knowledge to use those decision rights appropriately. This control problem is solved in a capitalist economy by a system of alienable property rights.

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 the 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.

Economics is a discipline that can help students solve the sort of problems they meet within the firm.