Arguments Against My Previous Post

and what is wrong with them

The talk my previous post was based on was given to MBA’s, people likely to work in firms. I started by telling them that I would deal with two questions, what they should do in their professional lives if they wanted to make the world better and how the legal system could make it in their interest to do it. I went on to argue that corporations should be run in the interest of their shareholders and describe legal rules to make it in the interest of their shareholders to run them that way.

I will consider two different approaches to critiquing that argument, one looking at the maximand, the sense in which the world is better or worse off, one looking at the means to maximize it.

The Maximand

Costs and benefits of what a firm does are transmitted to the firm as prices paid for inputs or received from outputs; prices reflect willingness to pay, value in dollars. Something a rich person is willing to buy or sell for ten dollars has the same weight in the firm’s decisions as something a poor person is willing to buy or sell for the same price. But ten dollars is probably worth more, in a more fundamental sense, to the poor man. This is the utilitarian argument against economic efficiency as a maximand.

The idea of economic efficiency is based on Alfred Marshall’s definition of an economic improvement, a change that increases total value measured by willingness to pay. Marshall, a utilitarian, argued that most economic changes affected a diverse mix of people so differences in the marginal utility of income, the utility value of a dollar, would usually average out, making increases in dollar value a good, although imperfect, proxy for increases in utility.

That argument can be supplemented by the observation that dollar value is observable in behavior, utility value us not. We know how to construct institutions that maximize dollar value, economic efficiency, as demonstrated in my previous post. We do not know how to construct institutions that maximize utility. That suggests that in constructing institutions maximizing efficiency may be the best we can do.

We may still be able to do better than that in our individual choices.

How To Maximize

One argument against shareholder primacy is that it ignores the effect of a firm’s decisions on people other than shareholders, most notably customers and employees, “Stakeholders.” Perhaps they too should have a vote in decisions of the firm.

The answer to this was offered in my previous post. Both customers and providers of inputs have their interests protected through the market. The firm must take account of the values of its customers if it wants them to buy from it, since they have the option of buying from someone else. It must take account of the values of its employees if it wants them to work for it since they have the option of working for someone else.

When the stock was initially issued potential shareholders had the option of investing in something else but thereafter they are stuck; they can stop being shareholders only by finding someone to sell their stock to. It is as if a worker, once hired, could only quit if he provided a replacement worker, a customer only stop buying if he found a replacement customer. The cost of a decision that makes things worse for employees or customers is that costs go up or revenue down. The cost of a decision that makes things worse for shareholders is that the price of shares goes down, a cost for the shareholder not the firm.

The market controls both what firms do and what firms exist. There are firms, worker cooperatives, owned by their workers; they get capital by selling bonds, which do not carry a vote, instead of stock. There are firms owned by their customers, customer cooperatives. Both forms are legal, both much less common than the joint stock companies I have been discussing.

Virtuous Treason

Stakeholder primacy is an institutional alternative to shareholder primacy, but there is also an individual alternative. I started my talk with the question of what the MBA’s in my audience ought to do in their professional lives. Some might have concluded that although shareholder primacy might be the right legal rule they could do better than that, whether judged by economic efficiency or some criterion they preferred.

As I tried to make clear in my previous post, the decentralized coordination of the market does an imperfect job of maximizing total value. There a variety of forms of market failure, of which externalities are a familiar example, situations in which costs or benefits of an individual’s acts are not costs or benefits to him, and similarly for a firm. It follows that an executive making decisions might increase economic efficiency by choices that reduce the firm’s profits but reduce the inefficiency due to some market failure associated with its actions, might for example choose to have his firm use a more expensive fuel because it produces less pollution. An executive whose objective is maximum utility rather than maximum dollar value might choose to hire applicants who badly need the job over more qualified ones who do not or deliberately overpay employees for whom the money is especially important.

Seen from the perspective of the individual executive this is a convincing argument; the only obvious rebuttal is that he is betraying the trust of the stockholders whose interest he is supposed to be working in. It is less convincing from an outside perspective. We trust participants in the market to make the right decisions both because they have the relevant information, their own preferences and abilities, their utility function and production function in the language of economics, and because they have the right incentives, bear the cost of their mistakes. The executive spending the shareholders money for his purposes has neither. He has no specialized knowledge in pollution control or the relief of poverty, no incentive to acquire it, no feedback on whether his decisions were correct. The argument looks convincing to him because he takes it for granted that his belief about what should be done, his solution to the part of the coordination problem that he can affect, is correct, his motives entirely benevolent. Seen from the outside, a decentralized solution to the problem that consists of permitting random individuals to allocate resources as they think best, to do good with other people’s money, looks much less likely to maximize either efficiency or total utility than the market solution.

It follows that the norms the executive is violating, norms against agents spending their principals’ money for what they want to do instead of for what their principals want them to do, in this context the norm of shareholder primacy, probably make the world better by either criterion. Individuals who see a way of allocating resources that would improve on the market outcome should do it with their own resources. The virtuous traitor may be working from the best of motives but, if detected, should be fired.

[There is a passage in one of C. Northcote Parkinson’s books which I wanted to quote here but I don’t have the book, at least can’t find it, and it is not in Parkinson’s Law, the only one available as a Kindle. It is a conversation between two executives over a request for a donation to a good cause. The first says that he will urge the company to make the donation. The second responds that he gave them five pounds and told them no. If any of my readers know the quote and where it is found, tell me in the comments and I will replace this with that.]

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