Contracting Costs

So far, we've considered two types of contracting costs:

1. direct bankruptcy costs [Warner (1977)]
2. indirect bankruptcy costs [Baxter (1967)]

Do these two costs lead to some optimal level of debt?

Jensen and Meckling (1976) introduce notion of "agency costs"

• parties to a contract have different (divergent) incentives
• parties will tend to act in their own best interests, not the best interests of the counterparty
• we typically think of the parties to a contract as being either a "principal" or an "agent"
• principals can limit the divergence between their interests and the interests of agents by giving agents appropriate incentives and by monitoring agents' activities (both of which are costly)
• agents can expend resources to guarantee that they will not take actions which are detrimental to principals or to ensure that the principal will be compensated if they do take such actions.
• typically, even after monitor by principals and bonding by agents, there will remain some divergence agents' incentives and those which maximize the welfare of principals.