Shareholder Capitalism and Stakeholder Capitalism: Commonalities and Differences

1. SHAREHOLDER CAPITALISM

The rationale behind shareholder capitalism is easy to spot. Firms need capital and the suppliers of capital seek returns on their investments. It follows, according to Shareholder Capitalism, that the interests of shareholders are preeminent in market-oriented economies.

The classic statement in support of Shareholder Capitalism comes from Milton Friedman,[1] winner of the 1976 Nobel Prize.[2] Friedman summed up his views about the “social responsibility of business” in Capitalism and Freedom (1962):

[T]here is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to engage in open and free competition, without deception or fraud.[3]

Friedman explained his argument in the context of a firm that is subject to regulations that limit how much it can pollute. His logic chain is as follows:

• Pollution abatement by firms is costly.
• Firms are subject to rules that require them to limit pollution to a specified level, P^max.
• Firms should meet but not go beyond the legal standard, i.e., they should not reduce pollution to a level below P^max.
• If firms abate (reduce) more than is required to bring pollution below P^max, they are taking profits away from Shareholders. Managers (agents) do not have the right to do so.

Several points are central to Friedman’s position:

1. It is up to the government to set the rules – in this case regarding pollution.
2. Firms should follow the legal rules.
3. Implicit in his view is that if firms routinely deviate from profit-maximization, the supply of capital to businesses will be reduced.
4. Friedman did not take into account the possibility (and now the likelihood) that employees, customers, shareholders and others in economic relationships with the firm might want the firm to do better than the legal standard for pollution and that such groups might be willing to give up some of their wages, pay higher prices, etc.
5. Friedman accepted that shareholders might want to do “good things” with their profits.

Friedman’s view, therefore, is that the firm’s sole objective is to maximize profits:

[1] Profits = Function (labor, capital, technology, managerial skill, legal compliance)

Importantly, Friedman did not incorporate into equation [1] other “right-hand side” variables such as the preferences of customers, employees, suppliers and others for doing better than what the law requires. Instead, Friedman’s view is based on an assumption that employees, customers, shareholders and others are (i) undifferentiated, i.e,. labor is labor, managers are managers, and (ii) are indifferent to whether the firm pursues social objectives.[4]

1. STAKEHOLDER CAPITALISM

The essence of stakeholder capitalism is that firms should pursue, and need to pursue, multiple objectives. Profit-maximization is one, but many others are relevant, including the welfare of the community and society, environment concerns, education, countering discrimination, and increasing access to health services.[5]

Professor Edward Freeman at University of Virginia led the efforts in recent decades to advocate for stakeholder capitalism.[6] Among the supporting rationales, Freeman argues that left to themselves, capitalism and markets will increase consumer welfare and generate gains for many, but will create social and economic divides. He also argues that markets are typically not capable of dealing with problems of environmental degradation and discrimination against less privileged groups.

In a 2007 article, Freeman and co-authors state:

If we rely upon the state to solve stakeholder conflicts, individuals and organizations never develop the imagination required to create different, mutually beneficial relationships. In addition, the parties are not expected to learn how to resolve issues themselves when the court system was created for such a purpose.[7]

According to Freeman and others who support Stakeholder Capitalism, businesses must become part of the solution to fundamental problems and commit to a broader set of objectives. This commitment could be viewed as in part self-interest, but Freeman recognizes that the pursuit of multiple objectives requires tradeoffs with shareholder interests. Indeed, Freeman rejects the notion that shareholders should set the rules:

One group’s rights do not prima facie dominate the narrative of capitalism. Rather, each stakeholder should be protected within their voluntary agreements.[8]

The bottom-line view of Stakeholder Capitalism is firms should explicitly pursue and report on multiple objectives. The specification of those objectives comes from cooperation, engagement, and processes that hold stakeholders responsible for actions that affect others. In the context of complex relationships, Freeman advocates for “continuous creation” of value on multiple dimensions, as suggested by this (incomplete) list of objectives:[9]

[1] Profits = Function (labor, capital, technology, managerial skill, legal compliance, customer preferences, employee preferences, supplier preferences)

[2] Environmental Stewardship = Function (labor, capital, technology, managerial skill)

[3] Community Welfare = Function (labor, capital, technology, managerial skill)

2. COMMONALITIES BETWEEN SHAREHOLDER CAPITALISM AND STAKEHOLDER CAPITALISM

If the narrow view of Shareholder Capitalism is modified to take into account the preferences of stakeholders who are in economic relationships with the firm, then the two views have substantial commonalities.

The profit function in [1] above for Shareholder Capitalism should be modified to include right-hand side variables such as (i) a desire among employees that the firm is a good environmental steward, and (ii) preferences among customers for green products. The result is that these other objectives are pursued as inputs into profit maximization.

Why would profit-maximizing managers take into account social objectives of employees, customers, and others? Standard economics explains why and also provides a framework for understanding the extent to which profit-maximizing firms will adjust their behaviors given the preferences of stakeholders with whom the firm has a contractual relationship, either explicit or implicit.

Consider employees who prefer to work for ethical companies that are good stewards of the environment and support their local communities. These preferences affect the salaries that they are willing to accept.

In State of the World 1, the firm does not take actions to protect the environment or support local communities. Its supply of labor is indicated by S¹.

In State of the World 2, the firm actions to protect the environment and support local communities, the supply of labor is indicated by S².

Holding constant the firm’s demand for labor (D), the firm benefits from being a good environmental steward and providing support for local communities. As depicted in Figure 1, the firm can hire more employees at lower equilibrium wages.

This standard result in economics is sometimes referred to as a compensating differential. If the firm takes actions to protect the environment, etc. (moving from State of World 1 to State of World 2), then potential employees are willing to accept lower wages, as indicated by the vertical distance between the two supply curves. This also means that potential employees need to be compensated extra for working for a firm that makes no efforts beyond the legal minimum. (This same phenomenon explains why firms sometimes make efforts beyond what is required by law to ensure a safe working environment.)

Allowing for a continuum of potential efforts to advance objectives that are of interest to employees, customers, and others leads the profit-maximizing firm to choose the effort level at which the marginal gains from hiring more workers at lower wages equals the marginal cost of those efforts. This optimization is expected to involve engagement, communication, and the development of processes that align efforts around social objectives.

This modification means that according to both Stakeholder Capitalism and Shareholder Capitalism firms should alter their behaviors and pursue social objectives. In contrast to critics of the Shareholder Capitalism, firms will take social objectives into account because doing so maximizes the value of the firm.

Note: Academics label this as instrumental stakeholder capitalism.

It also means that CEOs – whether they are pure profit-maximizers or not – may engage in similar activities to energize stakeholders, communicate their commitment to social objectives, and report to stakeholders on a range of objectives. Firms that fit both models may engage in, for example, design thinking to identify innovations that allow the firm to pursue stakeholder and shareholder objectives more effectively.

Another commonality is that firms may go beyond legal requirements to strengthen their social license to operate. Shareholder Capitalism would endorse investments in a firm’s social license because it is correctly viewed as an input into profit-maximization. Firms with stronger social profiles may have lower entry costs and less friction with government regulators.

Question: Does the fact that profit-maximizing firms will incorporate into their decision-making objectives such as environmental stewardship and support for communities mean that Shareholder Capitalism and Stakeholder Capitalism converge completely?

The answer is No. They converge to an extent that is determined by (i) whether stakeholders in economic relationships with the firm care about various social objectives, and (ii) their willingness to accept lower wages (in the case of employees) or pay higher prices (in the case of consumers.), and (iii) the return on efforts to strengthen the firm’s social license.

One last commonality is, whatever their objectives, firms are subject to internal and external constraints. Public companies have boards of directors with powers to choose senior executives and develop compensation schemes. In general, firms face competitive constraints in the markets in which they operate. If one consumer products company emphasizes environmental stewardship, they may lose some customers to rivals who offer lower prices. Other constraints derive from the market for corporate control. Firms that are viewed as trading off profits for social objectives may attract activist investors. Lastly, public firm face competition from alternative ways of organizing commercial activities. These include private companies and non-profits.

One last note: While sometimes it is argued that Shareholder Capitalism is inherently “short-term” oriented compared to and that Stakeholder Capitalism is concerned with long-term objectives, there is no real basis for these claims. If one believes that U.S. corporations are focused only the next few quarters, one needs to explain why U.S. corporations produce greater returns over the long term. Whatever the objectives, firms are expected to value the gains over time. In neither case does the value of the enterprise have a fixed time-horizon. The effective time horizon depends on the discount rate, but there is no reason to expect that the approach a firm takes will imply a different discount rate. The safer assumption, therefore, is that common to both approaches is long-term value creation, appropriately discounted.[10]

3. DIFFERENCES BETWEEN SHAREHOLDER AND STAKEHOLDER CAPITALISM

We’ve established that the most important difference between the two approaches concerns whether firms pursue a single objective, profit-maximization, or they pursue multiple objectives.

The second most important difference is that profit-maximizing firms are expected to expend less resources on social objectives than firms that pursue these objectives independently of profit-maximization. The reason is that profit-maximizing firms will expend resources only to the point where they benefit financially in their relationships with employees, customers, and other stakeholders. By contrast, firms that follow the stakeholder model will make efforts to generate various types of social goods beyond the level that makes sense in terms of financial returns.

A third potential difference is that the internal and external constraints on firm behavior are likely to have a more binding effect on firms that follow the Stakeholder Capitalism model. If socially-minded firms are in a highly rivalrous situation, of if poor financial performance makes insolvency more likely, then they are limited in their pursuit of social objectives.

4. DIAGRAM SUMMARIZING THE DIFFERENCE BETWEEN THE TWO MODELS

The Production Possibility Frontier (PPF) – a standard economics tool – is useful for analysis of Shareholder Capitalism and Stakeholder Capitalism.

Given their capabilities, firms can generate different combinations of profits and social goods (G). For expositional simplicity, social goods are represented as a single output.

Figure 2 on the next page shows profits (Π) on the vertical axis and social goods (G) on the horizontal axis. Maximum profits ((Π^max) is where the PPF reaches its highest point. The maximum amount of social goods (G^max) that the firm can generate is where profits are zero.

The insight that profit-maximizing firms will benefit from producing a positive level of social goods is reflected in the part of the PPF that has a positive slope.

Over the range of 0 to G^, the firm’s profits increase because employees, customers, and others compensate the firm for producing social goods. The firm’s overall labor costs are reduced due to lower wages or increased productivity. Similarly, the firm’s sales are enhanced by consumers who are willing to buy more from, and pay more to, firms that produce social goods.

What happens if the firm produces G^ but no more than that level of social goods? It maximizes profits. However, if the firm produces more than G^, then it faces a tradeoff between social goods and profits, as indicated by the negative slope. Put more starkly, the part of the PPF to the right of G^is the range where the firm sacrifices profits for social goods.[11] This is reflected in the negative slope between profits and social goods.

The firm may be able to produce a higher level of social goods, G⁺ provided that it is not constrained by its board of directors or by activist investors. The constraint on public firms in shown in Figure 2 as a horizontal line at Π^min.

In sum, firms that follow the stakeholder model will produce a higher level of social goods than firms that follow the shareholder model.

5. THE FIRM: WHAT IS IT? WHO’S IN CHARGE?

This brief refers to “the firm” but it has not defined the term. One view of the firm is that it is a nexus of contracts, both explicit and implicit. This view is consonant with Yale SOM’s integrated curriculum. See https://som.yale.edu/programs/mba/curriculum/year-1-core

Even if that answer makes sense, the next question is “Who is in Charge?” The single most important academic article on this topic – and the most cited article in the field of financial economics – is by Michael C. Jensen and William H. Meckling.[12] They focus on the relationship between Boards of Directors, which represent the interests of shareholders, and CEOs and their teams.

A common-sense point from their analysis is that CEOs may not take actions that maximize profits over the long term, which Jensen and Meckling distill to maximizing the market value of the company. Why might CEOs not follow Board dicta? One is, of course, that they think the Board is wrong about what actions do maximize long term value. A second category of reasons is that CEOs may have other objectives. They may have “pet projects”; they may enjoy have a larger than optimal staff; they may want to take actions that increase their personal capital; they may want a platform to use for political or social purposes; etc.

One helpful way to analyze Board – CEO relationships is to view the Board as the Principal and the CEO as its Agent. The Board hires the CEO, but it cannot write a complete contract that specifies what the CEO should do to maximize profits over time and in all states of the world. In addition to the “incomplete contract,” in practice CEOs and their teams typically know a lot more about the business than the Board members. Another advantage to incumbent CEOs is that it is costly to replace them. It follows that CEOs may not maximize the corporation’s objectives as defined by the Board. Jensen and Meckling refer to this as opportunistic behavior.

Two hundred years earlier, Adam Smith (1776) identified this exact problem in The Wealth of Nations. “Managers don’t watch over [the profitability of the business] with the same anxious vigilance” as the owners would want.

How can the Board constrain opportunism? A huge innovation is to align the interests of the management with the interests of shareholders by structuring their compensation as a function of profitability. CEO pay packages over the last 50 years have moved away from a reliance on base salaries to components such as bonuses, stock options, and equity vesting over time.