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Kenan Institute 2024 Grand Challenge: Business Resilience
Market-Based Solutions to Vital Economic Issues
Kenan Insight
Nov 16, 2021

Is Shareholder Primacy the Democracy of Capitalism?

Winston Churchill once quipped that “democracy is the worst form of government – except for all those others that have been tried.” As we begin to explore stakeholder capitalism – the idea that businesses would improve societal outcomes by focusing on a mandate broader than that which benefits shareholders alone – we believe it is important to start by discussing the existing best-practice model: shareholder capitalism.

The beauty of shareholder capitalism is that, under the right set of conditions, it produces the optimal amount of goods and services at the lowest cost with the least waste. This is by no means a perfect model because it does not account for harm to common goods, such as pollution, or what economists call negative externalities. However, in theory, all parties – workers, managers, shareholders, consumers and regulators – under shareholder maximization know what a company is up to and that they are in the business of making money. As a result, policymakers, investors and consumers can create structures and incentives which shift toward outcomes that solve for negative externalities, such as minimizing pollution or misinformation.

We have just sketched out the perfect world of shareholder capitalism, and we know the world is not perfect. However, before we scrap the shareholder capitalism model, perhaps we should look at ways of improving it and examining whether stakeholder capitalism is ready to take its place.

Shareholder Capitalism: From Textbook to Reality

The textbook model of shareholder capitalism is that a firm tries to maximize profits by producing the highest output at the lowest cost. All of managements’ decisions are based on that principle: hire the workers with the right skill sets and/or train those workers; invest in plant, equipment, software, and research and development; and produce a good or service (predominantly services these days) that customers want to buy. Demand and supply respond to changes in prices and tastes – such as customers wanting more organic food or electric cars – because firms are chasing those profits. Workers are incentivized through pay, bonuses and perhaps an ownership stake to produce the quality of products the firm chooses to sell – such as cheap, low-quality products like no-frills air travel. Firms choose the mix of inputs based on cost-benefit analyses and make long-term investments in capital and labor so that they can keep generating profits. Nothing is wasted, because waste eats into profits.

In the ideal setting, shareholder capitalism produces an efficient allocation of resources. Competitive markets with widely available information mean that consumers know the quality of the good or service they are buying. Likewise, management is in sync with shareholders. Perhaps most important, governments adjust for externalities and create a regulatory environment that ensures competitive markets and the free flow of information. In some ways, the U.S. of 1970, when Milton Friedman wrote A Friedman doctrine‐- The Social Responsibility of Business Is to Increase Its Profits, may have been closer to this textbook model. Figure 1 below illustrates the meaningful decline in competition over the last 15 years, with research suggesting it goes back much further.1 The increased firm concentration we see today means higher prices, lower output, less dynamism and fewer startups.2

Figure 1: Industry Share of Sales of Four Largest Firms

Source: MSCI, based on investable market

While the information age has provided more information about some goods and services, there seems to be an underestimation of the value of personal information. Do consumers understand that free goods, such as social media and mapping software, are not really free? The information consumers provide when using these free goods is far beyond the scope captured in the over-the-air television-advertising model. Moreover, society is only starting to understand the costs of misinformation. (Stay tuned for further discussion on the complexity of this issue in future Kenan Insights.)

The information divide points to potential failings in the regulatory sphere: regulators’ inability to keep up with the pace of change or their increased capture by larger, more dominant firms. This implies that the public sector may not be acting for the public benefit. Furthermore, the challenging politics around regulatory and, in particular, environmental policies, as well as the global nature of the problem, means that policymakers are failing to enact policies that deal with negative externalities. As noted in ESG Investing: Cure-all or Placebo?,the economics community across the political spectrum has long held that carbon pricing can be a significant change agent by creating incentives for businesses and consumers to lower their carbon footprint. Yet, as the just-completed COP26 indicates, policymakers are unable to agree on this solution on a global basis.3

Short-Termism, Agency and Measurement

In the textbook explanation of firms described above, firms take a long-term view and thus treat labor, communities, suppliers and customers as long-term partners in the pursuit of profit. A number of issues can attenuate the focus: agency problems, which drive a wedge between management and shareholders4; transient investors’ pursuit of short-term profits5; and operational challenges, which make it difficult for management to focus on the long-term pursuit of profit. We believe that incorporating some environment, social and governance (ESG) principles into the standard shareholder model can be part of the solution. For example, research has illustrated the benefits of employee satisfaction on profitability.6 Future Kenan Insights will discuss some of the governance-based solutions to agency and operational issues, with a particular focus on how incorporating beneficial diversity, equity, and inclusion principles can benefit firms. We are also exploring whether the increase in passive and ESG-focused investors creates greater incentives for firms to take the long view. However, as we will discuss below, it is also important to acknowledge when the tradeoffs are complicated.

The operational challenges of shareholders and management defining clear and measurable goals, which foster pursuit of long-term profits, is often overlooked. Research suggests that it is difficult to incentivize managers and workers to multitask (i.e., maximize current profits and invest for the future).7 One way of getting there is to provide a clear scorecard and measurements for managers and workers objectives, which indicates how much their efforts should be focused on the different metrics. UNC Kenan-Flagler Business School Professor Eva Labro, a Kenan Institute researcher, has found that many companies don’t even attempt to specify weights on the various measures in their scorecards, and those that do often have shifting weights over time.8 Solving  internal weights and measurement issues is an important part of standard profit maximization models, and becomes even more pressing when additional maximization goals are introduced, as is the case in a stakeholder capitalism framework.

The Case for Stakeholder Capitalism (or Fixing Shareholder Capitalism)

Ultimately, many look at rising profits as a share of the economy (Figure 2) and argue that firms must be taking the long view. We do not know the counterfactual. Would profits have been even higher without the potential short-termism described above? This graph is also an illustration of why many are focused on stakeholder capitalism. Shareholders are taking a larger piece of the economic pie while workers are getting a smaller slice (Figure 3).

Figure 2: After-Tax Corporate Profits (Share of GDP)

Figure 3: Labor Compensation (Share of GDP)

As alluded to above, the 1970 Friedman doctrine was written when profit shares had declined and labor shares were at their peak. This raises the question of whether we should first try to fix shareholder capitalism by solving the market failures described above and returning to a more competitive and regulated system, or whether we should move to a stakeholder system.

Part of the challenge with stakeholder capitalism is that we have a hard time describing a textbook model of the system, incorporating incentives and tradeoffs. John Elkington envisioned the triple bottom line, in which companies are simultaneously focused on profit, people and planet. As economists, we naturally ask if there is a clear framework for how to weigh these three different priorities. Should an electricity utility company build a dirtier power generation facility in its locality, thus creating more jobs in its community, or should it build a greener plant across the country? In a shareholder primacy world, the CEO would evaluate the costs and benefits of those choices. Does investing in the local community increase worker productivity and local demand? Do consumers demand more green energy, or have governments provided tax benefits or imposed taxes or regulations that sway in a certain direction? Some of these questions can be solved by better measurement and information. For example, one of the outcomes of COP26 is to create a clearer ESG framework. However, as discussed above, solving these weights and measures issues may not be enough.

In our view, those advocating for stakeholder capitalism must clearly articulate how companies will compel themselves to achieve outcomes that are not in the best interest of shareholders. There are fundamental legal reasons why this could be a challenge, such as management’s fiduciary responsibility to shareholders. However, there are likely market forces in play as well. A company that sacrifices shareholder profits for the benefit of other stakeholders could lose its competitive position in the market if not all industry participants follow the model. In other words, how does stakeholder capitalism prevent defections? If it is through regulation, then we are back to the shareholder supremacy paradigm. The stakeholder model may be able to solve some problems that are inside the firm, including governance and diversity issues. However, as the model seeks solutions to important externalities, such as environmental impacts, are we asking too much of what is ultimately the benevolence of corporate shareholders? 

In his 25-year retrospective, Elkington notes that the triple bottom line is about more than measurement and tradeoffs; it is “a genetic code for tomorrow’s capitalism, spurring the regeneration of our economies, societies and biosphere.” Returning to Churchill’s quip, we wonder how much of that DNA will be shareholder capitalism corrected for the market imperfections described above, and incentivized by investors, consumers and government policy. Our Kenan Insights throughout the next year aim to help resolve some of these questions in a rigorous, solutions-based manner.

1 Shapiro, C. (2019). Protecting competition in the American economy: Merger control, tech titans, labor markets. The Journal of Economic Perspectives, 33(3), 69-93. https://doi.org/10.1257/jep.33.3.69

2 Shambaugh, J., Nunn, R., Breitwieser, A., & Liu, P. (2018). The State of Competition and Dynamism: Facts about Concentration, Start-Ups, and Related Policies. The Hamilton Project. https://www.hamiltonproject.org/papers/the_state_of_competition_and_dynamism_facts_about_concentration_start_

3 Stubbings, C. (n.d.). Could global carbon pricing pay for itself? PriceWaterhouseCooper. https://www.pwc.com/gx/en/services/sustainability/publications/cop26/could-global-carbon-pricing-pay-for-itself-pwc-cop26.html

4 Jensen, M. C., & Meckling, W. H. (1976). Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure. Journal of Financial Economics 3, 306-360.

5 Bushee, B. J. (2001). Do Institutional Investors Prefer Near-Term Earnings Over Long-Run Value? Social Science Research Network. https://papers.ssrn.com/abstract=264299

6 Edmans, A., Li, L., & Zhang, C. (2020). Employee Satisfaction, Labor Market Flexibility, and Stock Returns Around the World. Social Science Research Network. https://doi.org/10.2139/ssrn.2461003

7 Holmstrom, B., & Milgrom, P. (1991). Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design. Journal of Law, Economics, & Organization, 7, 24–52.

8 Hemmer, T & Labro, E. (2017). Management Accounting and Operations Management. In M. Starr and S. Gupta (Eds.), Routledge Companion for Production and Operations Management (1st ed.). Routledge. https://www.routledge.com/The-Routledge-Companion-to-Production-and-Operations-Management/author/p/book/9781138919594

8 Kenton, W. (2021, March 16). Triple Bottom Line. Investopedia. https://www.investopedia.com/terms/t/triple-bottom-line.asp

9 Elkington, J. (2018, June 25). 25 Years Ago I Coined the Phrase “Triple Bottom Line.” Here’s Why It’s Time to Rethink It. Harvard Business Review. https://hbr.org/2018/06/25-years-ago-i-coined-the-phrase-triple-bottom-line-heres-why-im-giving-up-on-it

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