What Should Be the Objective of the Firm?
The academic literature about the nature of the firm has traditionally focused on two research questions aimed at understanding the role of firms in capitalist economies. The first question was first raised by Ronald Coase in his paper The Nature of the Firm (Coase 1937). In it, the British economist put forward a rationale for the existence of firms. Coase tried to answer the following question: why do firms exist?
In effect, the very existence of firms in market economies could be considered an anomaly. By their own nature, the functioning of enterprises seems at odds with the spirit of the market. Whereas firms are centrally-planned entities where decisions are made top-down through the figure of the entrepreneur, the market is a decentralized institution in which economic agents make their own decisions regarding what to buy, sell or produce based on signals provided by the price system (Hayek 1945).
Coase explains this apparent contradiction by drawing on the concept of transaction costs, which could be defined as those costs arising from exchanging goods and services in the market. In the absence of firms, all transactions would be carried out through market mechanisms. In such a world, transaction costs would make economic activity impossible.
Imagine that an entrepreneur had to sign contracts with all its employees (strictly speaking they would not be employees but self-employed workers) on a daily basis. Legal fees would be so high that making a profit would be extremely difficult. Coase points out that this is exactly the reason why firms emerge: to minimize transaction costs, and thereby maximize value creation.
The second research question is linked to the objective of firms. Traditionally, it was thought that a firm’s goal was to create value for their shareholders. This idea was explicitly articulated by the Michigan Supreme Court in 1919 (Sundaram and Anant 2004):
The business corporation is organized and carried on primarily for the profit of stockholders. The powers of the directors are to be employed for that end. (2004, p. 351).
More recently, Milton Friedman restated this idea in relation with the emergence of the concept of corporate social responsibility. Friedman argued that the only social responsibility of firms is to increase its profits and, thus, maximize shareholder value (Friedman 1970).
This view was challenged by R. Edward Freeman with the publication of Strategic Management: A Stakeholder Approach (Freeman 1984). According to Freeman, the aim of the management team should not be to create value for shareholders. Instead, managers should focus on reaching a balance between the difference stakeholders of the company (suppliers, customers, employees, shareholders, debtholders, etc.) In other words, the goals of all stakeholders must be incorporated in the decision-making process.
It seems obvious that the stakeholder approach is more appealing than the value-maximization theory vindicated by Friedman and others. After all, the idea that all stakeholders should be taken into account when making strategic decisions seems, on the surface, ethically superior. Why should the interests of greedy shareholders prevail over the interests of other stakeholders? However, as we will see, stakeholder theory rests upon flawed pillars.
First, the idea that managers should make decisions on behalf of all stakeholders is simply a chimera since the goals of the different stakeholders diverge and, on most occasions, conflict with each other (Sundaram and Anant 2004). As a result, adopting the stakeholder approach would inevitably lead to a more confusing decision-making process in which managers could justify any redistribution of wealth within the company in favor of any of the constituencies (managers included) drawing upon the “balance of interests” argument (Jensen 2002). As pointed out by Michael C. Jensen,
By gutting the foundations on which firm’s internal control system could constrain managerial behavior, stakeholder theory giver unfettered power to manager to do almost whatever they want, subject only to constraints by the financial markets, the market for control, and the product market […] In addition, stakeholder theory plays into the hands of special interests who wish to use the resources of firms for their own ends. (2010, pp. 242–243).
Another corollary of the stakeholder approach is that it entails a de facto democratization of the firm, which would necessarily result in the redistribution of the residual rights of shareholders (Andrés and Azofra 2008). This in turn would deter potential investors from taking risks, undermining one of the pillars upon which economic growth is based in market economies. In addition, firms would be confronted with the problem of aggregating preferences in such a manner that all stakeholders could maximize their respective utilities. However, as shown by Arrow’s Impossibility Theorem, this is unattainable (Andrés and Azofra 2008).
In contrast, the value-maximization theory focuses on increasing the long-term market value of the firm (Jensen 2002). This objective is not only compatible with the welfare of other stakeholders, but it is also the most efficient way to achieve it. Let’s take the case of employees. How can they obtain higher wages? In a market economy, increases in marginal productivity push wages up. Since higher productivity leads to value creation and maximizing value is the main goal under this paradigm, wages will be sustainably increased if and only if value creation is placed as a top priority.
Jensen proposes enhancing value-maximization theory with some aspects of stakeholder theory in what he calls Enlightened Value Maximization (Jensen 2002). This implies giving stakeholders the necessary tools and incentives that allow them to concentrate on maximizing long-term value. Yet this should not be considered a third way between value-maximization and stakeholder theories. Jensen simply incorporates certain nuances to the classical value-maximization theory to shield it against criticisms.
It should also be noted that value-maximization theory as presented by Jensen has been confirmed by empirical research (Wallace 2003). Wallace shows that stakeholders’ benefits increase when value is created. Therefore, the well-being of stakeholders depends on firms being able to maximize long-term value.
On balance, stakeholder theory is an inadequate framework to analyze the firm from a teleological point of view. Firms that depart from the value-maximization paradigm will find themselves unable to survive in the long-term. Focusing on value creation seems the only way for companies to maximize the utility of all stakeholders while improving the welfare of society as a whole.
Bibliography
de Andrés Alonso, Pablo, and Valentín Azofra Palenzuela. “El enfoque multistakeholder de la responsabilidad social corporativa: De la ambigüedad conceptual a la coacción y al intervencionismo.” Revue Sciences de Gestion–Management Science–Ciencias de Gestión (ISSN 66 (2008): 69–90.
Coase, Ronald H. “The nature of the firm.” Economica 4.16 (1937): 386–405.
Freeman, R. E. 1984. Strategic Management: A Stakeholder Approach. Pitman, Boston, MA.
Friedman, Milton. “The Social Responsibility of Business Is to Increase Its Profits.” The New York Times, The New York Times, 13 Sept. 1970, www.nytimes.com/1970/09/13/archives/article-15-no-title.html.
Hayek, Friedrich August. “The use of knowledge in society.” The American economic review (1945): 519–530.
Jensen, Michael C. “Value Maximization, Stakeholder Theory, and the Corporate Objective Function.” Business Ethics Quarterly, vol. 12, no. 2, 2002, pp. 235–256.
Sundaram, Anant K., and Andrew C. Inkpen. “The corporate objective revisited.” Organization science 15.3 (2004): 350–363.
Wallace, James S. “Value maximization and stakeholder theory: Compatible or not?.” Journal of Applied Corporate Finance 15.3 (2003): 120–127.