REMM Jensen Meckling The Nature of Man – part 2
American youth for vandalism, punishment for infraction of Singapore law is carried out swiftly and publicly. Educating people about the effects of their choices does, of course, affect behavior, and it takes time for cultural attitudes to change. A complete programmatic attack on crime would include the use of both formal punishments and rewards as well as education and consensus building among the population. Properly carried out, such education and consensus building can tap social rejection and approval as additional (and decentralized) sources of punishments and rewards to reinforce sanctions against criminal or otherwise undesirable behavior. As another illustration of the workings of the sociological model, consider the current debate over the causes of homelessness. The very use of the term “homeless” 11 Sykes (1992, p. 3). Jensen and Meckling 21 1994 suggests no choice on the part of street people (who are therefore victims of the system); it also carries little or none of the social disapprobation of “vagrant,” a now unfashionable label. This change in language and attitudes reduces the decentralized sources of social or cultural punishment for being a street person—again something the REMM model predicts would result in an increase in this socially undesirable behavior. New York City now spends in excess of a half billion dollars a year on subsidies for the homeless, and the problem shows no signs of going away even with the improvement in the economy. (And the “de-institutionalizing” of the mentally ill, a common explanation, by no means accounts for the vast increase in the numbers of street people.) The sociological model suggests that if an individual’s income and wealth are small, it is entirely due to cultural factors, environmental adversity, or bad luck—not to conscious effort, the choice of leisure over work, the choice of a particular type of work, or the failure to invest in learning. Therefore, “justice” requires that we confiscate the wealth of the more fortunate to recompense the unfortunate. Of course, the higher the recompense, the more attractive it is to be poor, and REMMs will respond by taking more leisure, by choosing occupations in which employment is more unstable, and by investing less in learning. The REMM model predicts that if we make the payoff high enough, we can attract an arbitrarily large number of people to become poor or unemployed—or at least to meet the established criteria for those programs. This describes important aspects of our welfare and unemployment systems. Politicians, bureaucrats, and special interest groups understand that public policy choices are affected by the concept that individuals are responsible for their own fates. Strong popular support for the principle that individuals ought to be rewarded or punished in accord with their own behavior, means that measures that aim to redistribute wealth, or rehabilitate criminals rather than punish them, would encounter strong opposition. But resourceful politicians and others who want to put such measures into Jensen and Meckling 22 1994 effect can neutralize public opposition by persuading people that everything we do is forced on us by our cultural environment—we are social victims, and thus neither our behavior nor our status is a product of deliberate choice. By undermining the link between choice and consequences, they can overcome the resistance that stems from beliefs that individuals are responsible for their own behavior. In addition, individuals constantly face a conflict when attempting to help others who are experiencing difficulty, especially those related through family or other ties. The conflict is between the desire to ease or eliminate the difficulties of others through gifts or charity and the reluctance to distort the incentives of people to take charge of their own lives, say by investing in education and making other efforts to improve their condition. All parents face such trade-offs when deciding how much help to give their children, and the choices are not easy. The short-term pain associated with denying help to a loved one is very difficult to bear. But casual observation, together with evidence of the futility of various social programs, seem to indicate that people systematically underestimate the counterproductive long-run effects on individuals of actions that we take to shield them from the consequences of their own choices.12 The Sociological Model and Marxism A discussion of the sociological model would be incomplete without touching upon the use of that concept by Marxists, socialists, and other groups around the world. Marxist politicians understand that the sociological model is the foundation for the centralization of power. Marxism has received wide support in Europe. It has also had substantial support among the Catholic clergy and American academics. Recent evidence on the widespread failure of Russian, Eastern European, and other economies dominated by Marxist thought has revealed the shortcomings of this view and diminished, but not 12 The “tough love” movement and twelve step programs such as AA for treating substance dependence are designed to provide help while insisting that individuals maintain their personal responsibility for their fate. Jensen and Meckling 23 1994 eliminated, support for it. Ironically, as many formerly socialist Eastern European and Asian countries are moving toward capitalism, the U.S. is moving toward more socialistic regulatory and political policies. Socialism is supported by a philosophy that idolizes the state. The urge to subordinate the individual to the organization has ancient roots going back at least to Plato. In portraying his ideal state, Plato says: … [T]here is common property of wives, of children, and of all chattels. And everything possible has been done to eradicate from our life everywhere and in every way all that is private and individual. So far as it can be done, even those things which nature herself has made private and individual have somehow become the common property of all. Our very eyes and ears and hands seem to see, to hear, and to act, as if they belonged not to individuals but to the community. All men are molded to be unanimous to the utmost degree in bestowing praise and blame, and they even rejoice and grieve about the same things, and at the same time… Nor should the mind of anybody be habituated to letting him do anything at all on his own initiative, neither out of zeal, nor even playfully. But in war and in the midst of peace—to his leader he shall direct his eye, and follow him faithfully. And even in the smallest matters he should stand under leadership. For example, he should get up, or move, or wash, or take his means … only if he has been told to do so. … In a word, he should teach his soul, by long habit, never to dream of acting independently, and to become utterly incapable of it.13 Plato’s ideal state is an example of the most extreme anti-individualist position, one which makes the organization itself the ultimate end. The state is treated as a living organism; it is the overriding value. Individual purpose is not only unimportant, it is an evil that must be stamped out. Plato’s views are not very different from those of most Marxists. The role of the individual poses a dilemma for Marxists. Avowed Marxist states around the world such as the former USSR, China, and Cuba display an attitude with respect to individual citizens that is close to Plato’s utopia. Party doctrine denounces individualistic motivation and invokes the common good. In intellectual discourse, Marxist theorists press for an organizational or social class approach to the study of society. In Marxist theory, the 13 Plato, Laws 739c, ff., and 942a, f, as cited by Karl Popper (1950, p. 102). Jensen and Meckling 24 1994 worker and the capitalist play out their roles regardless of the costs and benefits of their actions. Capitalists are what they are and do what they do because they are capitalists, and so too for workers. In the Marxist model, individuals do not evaluate, choose, or maximize; they behave according to the sociological model. The sociological model is devoid of prescriptive content, yet it is commonly used for normative purposes. If humans are not evaluators (they only play the roles given to them by the culture), it is meaningless to talk about making people better off. While Marxists reject Western economic tradition of considering the individual as the basic unit of analysis, they also express great concern for the plight of the less fortunate and make much of concepts such as class conflict and exploitation. Thus, these concerns for the welfare of people (primarily the workers or underclass) exhibit an obvious and fatal inconsistency. To repeat, unless we attribute preferences to the individual, language that describes differences in an individual’s wellbeing makes no sense. Notions like equality and justice are popular among those who employ the sociological model of humanity, but such ethical norms are not internally meaningful because they imply that individuals care about their condition; that is, that they are evaluators, they experience envy, and they choose. Furthermore, if the state is all that matters, as Marxist doctrine maintains, concern for the plight of the individual is irrelevant at best and can be inimical to the general good. Concepts such as exploitation and conflict can be used in a group context to refer to more than one individual, but such language has meaning only in terms of individuals. Organizations cannot be exploited any more than machines or rocks can be exploited. Only individuals can be exploited, can suffer, can make war; only individuals can be objects of compassion. Organizations are purely conceptual artifacts, even when they are assigned the legal status of individuals. In the end, we can only do things to and for individuals. Jensen and Meckling 25 1994 7. The Psychological Model of Human Behavior The psychological model is a step up the evolutionary ladder from the sociological model. Like REMM, humans in this model are resourceful, they care, they have wants and drives. But the individual’s wants are viewed essentially as absolutes that are largely independent of one another. Therefore, substitutions or trade-offs are not part of individual human behavior. In effect, the individual is said to have “needs” in the sense of that word which we have already rejected. Perhaps the best-known formulation of what we call the psychological model was provided by A. H. Maslow. “Human needs,” wrote Maslow in 1943 (p. 370), “arrange themselves in hierarchies of prepotency. That is to say, the appearance of one need usually rests on the prior satisfaction of another more prepotent need.” Maslow’s needs, in order of their “prepotency” from high to low, are physiological (food, water), safety, love, and self-actualization. In contrast to REMM, the individual in Maslow’s hierarchy of needs model is unwilling to give up any food for any amount of safety until his or her food needs are satisfied. Only after the food needs are completely satisfied will he or she be concerned about safety. What Maslow and his followers have done is to confuse two entirely different issues: how an individual allocates resources among alternative goods at a given level of wealth, and how that allocation pattern varies as an individual’s wealth rises. Maslow himself, in the latter part of his famous article, qualifies his early statements that deny substitution. He argues that he did not mean that literally 100% of a person’s food need had to be satisfied in order for him or her to begin to satisfy the safety needs, and so on.14 Although most of Maslow’s followers have ignored his 14 “So far, our theoretical discussion may have given the impression that these five sets of needs are somehow in a step-wise, all-or-none relationship to each other. … This … might give the false impression that a need must be satisfied 100 per cent before the next need emerges. In actual fact, most members of our society who are normal, are partially satisfied in all their basic needs and partially unsatisfied in all their basic needs at the same time. A more realistic description of the hierarchy would be in terms of decreasing percentages of satisfaction as we go up the hierarchy of prepotency. … Jensen and Meckling 26 1994 qualifications, these latter statements show him moving toward the notion of substitution and the income elasticity of demand, a relationship known to economists for many years and incorporated in REMM.15 Moreover, ample evidence of human behavior contradicts Maslow’s hierarchy of needs model. We see astronauts, skiers, and car racers accepting less safety in return for wealth, fame, and just plain thrills. Poets, artists, and gurus go without material comforts to devote their time to contemplation and art; and, to us, these pursuits sound closer to self-actualization than physiological goods. The psychological model, like the sociological model, is not satisfactory for describing the behavior of individuals in the study of social phenomena. Yet there is some content in Maslow’s model. His ordering of wants probably corresponds to how most people would allocate a $1,000 increment of wealth on expenditures at increasing levels of wealth. Wealthier people will tend to spend less of their additional wealth on goods satisfying physiological wants, and more on each of the categories of goods higher in Maslow’s hierarchy.16 Nevertheless, inconsistent with Maslow’s model, individuals at any level of wealth are willing to sacrifice some amount of any good for sufficiently large amounts of all other goods. Thus, while Maslow’s ordering of categories of human wants tends to describe how expenditures increase with increased wealth, it is neither a hierarchy nor does it describe needs. It is difficult to infer much else about social behavior from the hierarchy of needs model that is not trivial or false. The psychological model predicts that if the cost of any good rises, the individual will reduce outlays on whatever is the highest As for the concept of emergence of a new need after satisfaction of the prepotent need, this emergence is not a sudden, salutatory phenomenon but rather a gradual emergence by slow degrees from nothingness.” Maslow (1943, p. 388-9). 15 The income elasticity of demand describes how an individual’s consumption of a good changes with a given change in income. It is the percentage change in the quantity of a good demanded by an individual divided by the percentage change in the individual’s income (holding all prices and quantities of other goods constant). 16 Economists call such goods “necessities” and “luxury” goods. They are defined by their income- or wealth-elasticity of demand. Jensen and Meckling 27 1994 ranking good he or she currently buys, a behavioral reaction clearly contradicted by actual consumer behavior. When the price of one good rises relative to other goods, consumers react by reducing purchases of the good whose price has risen, not the purchases of goods that are highest on Maslow’s list. Once substitution is ruled out, the individual’s attempt to maximize by reconciling wants with means is largely ignored, and attention focuses instead on the study of individual wants (or classes of wants). Examples from the field of organizational behavior (OB) are numerous. One general problem (an extremely important one) is how to get employees to be more productive. The general answer under the psychological model is to reward them by satisfying their needs. The OB literature does not generally recognize that the employer’s problem is one of designing an overall employment package that takes into account the potential for trade-offs. Instead, each good that the employer can provide the employee is considered in isolation. Job enrichment and the quality of the working environment are examples. More of each is always taken to be better than less, and not only is the optimality criterion seldom applied to determine the correct level of job enrichment or quality of the environment, optimality itself is seldom discussed. The prevalence of Maslow’s model in the behavioral science field is, we believe, a major reason for the failure of the field to develop a unified body of theory. Theory erected on the basis of individuals who are driven by wants, but who cannot or will not make substitutions, will necessarily consist of a series of independent propositions relating particular drives to actions and will never be able to capture the complexity of human behavior. Jensen and Meckling 28 1994 8. The Political Model of Human Behavior While resourceful and, in a certain sense, evaluators and maximizers, individuals under the political model evaluate and maximize in terms of other individuals’ preferences rather than their own. Unlike REMM, the individual is a perfect agent seeking to maximize “the public good” rather than his or her own welfare. It is important to distinguish between altruism (that is, a willingness to sacrifice some of one’s own goods, time, or welfare for the benefit of others) and the political model. Altruists do not behave according to the political model. Since they have their own preferences, they cannot be perfect agents. A perfect agent is a person that will maximize with respect to the preferences of the principal while, if necessary, denying his or her own. Perfect agents would be equally satisfied working to save the whales, feed the poor, make computers, or care for the musical interests of the rich through the local symphony orchestra at the bidding of their employers. Altruist that she is, Mother Teresa’s devotion to caring for the poor of Calcutta does not make her a perfect agent. It is highly doubtful that she would agree to (or effectively) represent the interests of someone who wished to save the whales, or to make computers. Like all REMMs, she has her own preferences and will exercise her own choice over whom she devotes her time to helping. The logic in which the political model figures so prominently is simple, though it will not withstand careful scrutiny. Whenever individuals acting on their own behalf will not bring about the “desired” outcome, government must take a hand. If consumers might be misled by deceptive advertising, have government regulate advertising. If sellers might market products that are harmful to consumers, have government regulate consumer product safety. If consumers might not understand the terms of lending contracts, have government regulate the language that can be used in such contracts. These solutions serve two powerful interests: first, the strong tendency of people to avoid taking responsibility for themselves, and second, the degree to which these solutions Jensen and Meckling 29 1994 increase the power and reach and, therefore, the self interest of politicians and bureaucrats. The fatal flaw in the above propositions is their assumption that when politicians intervene, they act to accomplish the desired result—that is, they act in the public interest. Those who argue for such government intervention simply assume that politicians can and will behave in accord with the desires of the electorate. The political or perfect agent model lies at the heart of virtually all campaigns that purport to solve problems by creating a governmental agency or appointing a political body. Worried about too many dangerous drugs or injuries in coal mines? Establish a Food and Drug Administration (FDA) to regulate drug testing and to grant approval for the marketing of new drugs. To reduce injuries in coal mines, pass a mine safety law with the Department of Mines to administer it. Unfortunately, the results of such programs do not lend support to the political model. After the 1962 amendments regulating the efficacy of new drugs, the number of new drug approvals in the U.S. fell by half.17 Moreover, between 1966 and 1970, more than 2,000 small nonunion coal mines closed down with no measurable reduction of injuries or death rates in coal mines.18 These results occur—and are indeed predictable—because the people who enact and administer the laws are REMMs. The bureaucrats in the FDA, for instance, face high costs if they err and allow a drug that has injurious side effects (such as Thalidomide) to be marketed. On the other hand, the people who suffer and die because FDA procedures have kept a new drug bottled up in the testing laboratories for several years (or perhaps never let it on the market) usually don’t even know that they have been harmed. Patients now able to get efficacious drug treatments in Europe that are not available in the U.S. are becoming aware of the consequences of FDA regulations, but their number is small. See Peltzman (1974, pp. 15-16), and Wardell, Hassar, Anavekar, and Lasagna (1978). Hansen (1982) reviews the literature on the effectiveness of the FDA drug regulation procedures, and Kaitin, Kenneth, Bryant, and Lasagna (1993) provide data indicating the average rate has not changed through 1990. 18 See Henderson, (1977). Jensen and Meckling 30 1994 Political action by AIDS patients and their advocates has persuaded the FDA to relax restrictions limiting access to promising AIDS treatments before they have satisfied all normal FDA regulations for public use. The mine safety law that closed down many nonunion mines was passed after active lobbying by both the United Mine Workers Union and the Bituminous Coal Operators Association (which represents the mining firms unionized by the United Mine Workers). Both of these groups faced competition from small mines that were generally staffed by nonunion labor. The costs imposed on these mines by the law were so onerous that many of them were driven out of business. Allegiance to the political model has been a major deterrent to the development of a body of theory that could explain with reasonable accuracy how the political system operates. Social scientists, especially political scientists, have been aware of the anxiety politicians exhibit to be reelected, and they have usually tacitly assumed that this induces them to behave in accord with the wishes of the majority. But this model of the legislative process is incapable of explaining what actually occurs. We know that legislators consistently vote for measures that cannot possibly be in the interest of a majority of their constituents. Except Wisconsin (and even there it is doubtful), there surely is no state in the Union where a majority benefits from government sponsorship of a cartel among milk producers. Other examples are tariffs on TV sets, oil import quotas, “voluntary” quotas on foreign automobiles, and punitive tariffs on flat panel computer screens, to name just a few. Elected officials (who are REMMs) sense that they have the opportunity to become entrepreneurs. They have access at relatively low cost to mass advertising via television, radio, newspapers, and magazines. The tenacity with which the government continues to regulate the media is not independent of their self interest in having access to shaping it and using it for publicity in a multitude of ways. Resourceful politicians also ally themselves with organized groups that get media attention and encourage the Jensen and Meckling 31 1994 organization of new groups. Indeed, now that the general nature of the process and the payoff to such organizations have been perceived, popular fronts have proliferated, each vying for publicity, even to the point of using violence to demonstrate their sincerity. Individually and collectively, legislators have an interest in enlarging the role of the state and, as REMMs, they engage in continuous marketing of programs to achieve that end. If crises do not exist, they create them, or at least the illusion of crises. Then they rescue their constituents from disaster with legislation that sacrifices the general welfare to benefit special interests. The Current Health Care Debate. For example, in recent years members of the Clinton administration and associated special interest groups have campaigned to create the public impression of a health care crisis and hence support for legislation to “reform” the U.S. health care system.19 The proposed changes would result in massive new regulation and centralization of the system. In so doing, it would transfer substantial control over an additional 14% of the U.S. gross national product to the government with obvious implications for the power base of the bureaucracy. Almost as clear, unfortunately, is the import of these changes for the efficiency and quality of U.S. health care. The proposed changes would result in a centralization and cartelization of the health care industry in the hands of government and newly proposed private bodies. This is exactly the wrong way to go with this industry. Because the specific knowledge of each case lies in the hands of the doctor and the patient, decision making in the health care industry, to be effective, must be decentralized and thus kept in their hands. The proposed centralized process for deciding on patient treatment and care will inevitably result in large declines in the quality of health care. Even ignoring the effects of the centralization, the Administration’s original plan to take $150 billion of annual costs (and, therefore, real resources) out of the system while adding as many as 37 19 See Stelzer (1994). Jensen and Meckling 32 1994 million people to it would reduce the quality and timeliness of future care and would also create shortages and lead to rationing. There is a U.S. health care problem, to be sure; but it does not stem from too little regulation and too few subsidies. Rather it comes from our third-party insurance system that effectively removes responsibility for the costs from the most important decisionmaker, that is, the patient. The key to solving this problem is to impose the financial consequences of their medical decisions on patients through greater use of co-pay insurance with larger deductibles that place first dollar costs on patients while protecting them against catastrophic illness. The Political Model in the Private Sector The political or perfect agent model is also widely used by managers of private organizations in managing their employees. Corporate managers often wish to believe that people are perfect agents with no preferences of their own. If there is a problem in part of the organization with a manager who is making the wrong decisions, the problems must come from having a “bad” person in the job. The solution is then to fire the manager and replace him or her with a new person. Tell that person (who is assumed to be a perfect agent) what you want done, and then wait for it to happen. In contrast managers using the REMM model would predict that if the manager has the proper talents and training, it is the organizational structure and incentives that are at the root of the problem. The solution would then be not to fire the manager, but to reform the organizational policies. Problems in organizations often arise because managers are rewarded for doing things that harm the organization—for example, empire building or maximizing market share at the expense of shareholder value. In compensating managers according to negotiated budgets, many companies effectively induce line managers to negotiate budget Jensen and Meckling 33 1994 targets that are well below the level that would maximize the value of the organization. The managers do this, of course, to ensure they can easily meet the target. In a related problem, large public corporations also regularly retain and tend to waste large amounts of free cash flow—that is, cash flow in excess of that required to fund all profitable projects of the firm. Spending the cash on acquisitions or other unprofitable projects (undertaken with the aid of unrealistically high forecasts of future profitability) gives management a bigger company to run, thereby increasing their power and prestige in the community. Because managerial pay tends to be positively related to the size of the company, these actions generally increase their compensation as well. In addition, keeping the cash in the firm gives them a cushion for spending during tough times, whether it is economic or not. Retaining the excess cash also makes it easier to avoid closing plants, laying off employees, cutting charitable contributions, and making the other hard choices associated with freeing up underutilized resources. Yet it is important for managers to make these difficult choices so that the resources can be put to higher-valued uses in the rest of society.20 9. In Closing We argue that the explanatory power of REMM, the resourceful, evaluative, maximizing model of human behavior, dominates that of all the other models summarized here. To be sure, each of the alternative models captures an important aspect of behavior, while failing in other respects. REMM incorporates the best of each of these models. From the economic model, REMM takes the assumptions that people are resourceful, self-interested, maximizer, but rejects the notion that they are interested in only money income or wealth. 20 See, for example, Jensen (1986, 1988, 1989a, 1989b) and Lang, Poulsen, and Stulz (1994), and Blanchard, Lopez-de-Silanes, and Shleifer (1994) and the references therein. Jensen and Meckling 34 1994 From the psychological model, REMM takes the assumption that income elasticity of demand for various goods has certain regularities the world over. Nevertheless, in taking on this modified notion of a hierarchy of needs, it does not violate the principle of substitution by assuming people have “needs.” From the sociological model, REMM takes on the assumption that “society” imposes costs on people for violating social norms, which in turn affect behavior; but it also assumes that individuals will depart from such norms if the benefits are sufficiently great. Indeed, this is how social change takes place. From the political model, REMM takes on the assumption that people have the capacity for altruism. They care about others and take their interests into account while maximizing their own welfare. REMM rejects, however, the notion that individuals are perfect agents. In using REMM, detail must be added (as we have done implicitly in the examples above) to tailor the model to serve as a decision guide in specific circumstances. We must specify more about people’s tastes and preferences that are relevant to the issue at hand—for example, by making explicit assumptions that people have a positive rate of discount for future as opposed to present goods, and that they value leisure, as well as intangibles such as honor, companionship, and self realization. Finally, combining these assumptions with knowledge of the opportunity set from which people are choosing in any situation (that is, the rates at which people can tradeoff or substitute among various goods and bads), leads to a powerfully predictive model. REMM is the basic building block that has led to the development of a more or less unified body of theory in the social sciences. For example, some economists, like recent Nobel Laureate Gary Becker, have applied REMM in fields previously reserved to sociologists such as discrimination, crime, marriage, and the family.21 Political scientists in company with economists have also employed utility-maximizing models of political 21 Becker (1968, 1973) on crime and marriage. Jensen and Meckling 35 1994 behavior to explain voter behavior and the behavior of regulators and bureaucrats.22 Still others are using REMM to explain organizational problems inside firms.23 For all its diversity, this growing body of research has one common message: Whether they are politicians, managers, academics, professionals, philanthropists, or factory workers, individuals are resourceful, evaluative maximizers. They respond creatively to the opportunities the environment presents to them, and they work to loosen constraints that prevent them from doing what they wish to do. They care about not only money, but almost everything—respect, honor, power, love, and the welfare of others. The challenge for our society, and for all organizations in it, is to establish rules of the game and educational procedures that tap and direct the creative energy of REMMs in ways that increase the effective use of our scarce resources. 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