Corporate governance and the theory of the firm are two of the fastest growing topics in modern economic theory, after a long silence since the publication of the seminal works by Berle and Means (1932) and Coase (1937). Berle and Means argued that modern US corporations were so dependent upon professional managers that a managerial economy had emerged, characterised by the separation of ownership from control in corporations. The managers decided upon the running of the corporation whilst the shareholders, though they were the owners, were only entitled to receive cash flows. This leads to potential conflicts between the interests of the shareholders and those of the management.
Following these two pioneering works, significant contributions have since been made in the areas of property rights theory (Alchian and Demsetz, 1972; Grossman and Hart, 1986; and Hart and Moore, 1990), agency theory (Jensen and Meckling, 1976), the theory of incomplete contracts (Williamson, 1975, 1985; Grossman and Hart, 1986; Hart and Moore, 1990), and transactions cost theory (Williamson, 1975, 1985). All these theories contribute from different angles to an understanding of the issues of corporate governance, and fundamentally affect our thinking about what is a firm, and in whose interests the firm is governed.
It is interesting to note that recent studies of corporate governance, which is a topic within the increasingly broad area of corporate finance, have merged into the area of the theory of the firm. As Zingales (2000) notes
The interaction between the nature of the firm and corporate finance issues has become so intimate that answering the fundamental questions in the theory of the firm has become a precondition for any further advancement in corporate finance.
The link between theory of the firm and corporate governance is even more compelling, and I have already argued for it in Zingales (1998). The word governance implies the exercise of authority. But in a free-market economy, why do we need any form of authority? Isn't the market responsible for allocating all resources efficiently without the intervention of any authority? In fact, Coase (1937) taught us that using the market has its costs, and firms