Shareholder Primacy

the least bad solution to the coordination problem

[Two days ago I gave a talk to a group of MBA’s at the Leavey School of Business. This was the central argument. The talk is webbed.]

To produce pencils you need wood. To get wood you need chain saws. To make chain saws you need steel, copper, gasoline. To make steel you need iron ore, coal. To mine iron ore you need miners and mining equipment.

Follow down the chain, branches included, and to produce pencils you need to coordinate the activities of millions of people, somehow arrange that enough miners are trained to make enough iron ore to make enough steel to make enough chain saws to produce enough wood for the number of pencils you are producing, and enough steel for … and enough miners to … .

That is the Coordination Problem. Your first conclusion after thinking through how hard the problem is should be that it cannot be done, hence our modern civilization cannot exist, hence most of us should have starved to death by now.

There are two solutions to the problem. The obvious one is centralized coordination, someone at the top figuring out what everyone else should do and telling them to do it. That works for coordinating a small number of people but scales badly. As the number of people being coordinated increases it becomes harder and harder for the person at the top to figure out what everyone should do, know what everyone is doing and make them do it, more and more likely that the person at the top, separated by many layers from the people he is supposed to be serving, will base his decisions on his interests rather than theirs. At the scale of a country it works catastrophically badly, as demonstrated by, among other things, the collapse of the Soviet Union.

The solution that works at scale is the decentralized one, each person solving a small part of the problem. For this to work, things have to be somehow set up so that it is in each individual’s interest to make the decision for his part of the problem that takes account of its effect on everyone else. That cannot be done perfectly but a market system, private property and voluntary exchange, does it surprisingly well.

In order to produce things I have to pay my workers enough so that working for me is at least as attractive as whatever else they could do with their time, pay for my inputs at least as much as they cost to produce or are worth to other people. Selling what I produce transfers the benefit of producing it back to me, so both costs and benefits to other people go into my calculation of what it is in my interest to do. If benefit is greater than cost it is in my interest to do it and in our interest for it to be done. Individual decisions add up to the right group decision. And the decentralized solution scales — up to the size of a global economy.

That is a very sketchy description of what takes a semester or two of price theory to adequately explain.¹

My description so far is of an economy where all production and consumption, all economic decisions, are made by individuals. That is not the world we live in. Most production is organized by firms, islands of centralized coordination in a sea of decentralized coordination. The capitalist beach is made up of socialist grains of sand.²

How can decentralized coordination incorporate firms as well as individuals and still take account of costs and benefits to everyone? For the firm as well as for the individual the price it must pay for inputs, including labor, transfers to it the cost to others of it using them. For the firm as for the individual, the price it is paid for its outputs transfers to it the benefits to others of what it produces. But the decision makers, the executives and board of directors, are not, like the individual producer, collecting the difference between revenue and cost. What should they be maximizing in order for decentralized coordination to take into account the effect on everyone affected of decisions they make? How can we make it in their interest to do so?

There are three groups of people affected by the firm’s decisions: employees, customers, and stockholders. The effect of those decisions on the employees is transferred to the firm as the cost of hiring them. The effect of those decisions on the customers is transferred to the firm as what the customers are willing to pay for what the firm produces.

Neither is perfectly transferred. If my employer does something that makes my job worse I cannot costlessly shift to my next best alternative; I have a variety of sunk costs in my present job, skills acquired that will not transfer, expenditures in time and money adapting to my present location. If Apple does something that lowers the value to me of Macintosh computers I cannot costlessly shift to another brand because I have spent time and effort learning to work with Apple hardware and software and the value of that knowledge will be sharply reduced if I shift to the most Mac-like distro of Unix. My wage somewhat underestimates the cost to me of working for my employer, the money Apple will get for the next Mac I buy somewhat underestimates the benefit to me of buying it. Both the effect of firm decisions on employees and customers are somewhat underestimated, especially in the short run, by the effect on the firm’s cost and revenue.

The effect of the firm’s decisions on the stockholders is not reflected at all on firm costs and revenues.³ A stockholder can only sell his stock at the price another investor will pay for it, a price which already incorporates the predicted effects of what the firm is doing. If the firm does something that makes its products worse it cannot sell them for as much, which is a reason not to. If it does something that makes working for it less pleasant it has to pay more to get workers, which is a reason not to. But doing something that reduces the dividends to the stockholders, such as paying executives more than necessary, costs the stockholders money — the value of their shares goes down — but that cost does not make the executives worse off so is not a reason for them not to do it.

I conclude that in order for market coordination to work, to take account of the effects of decisions on everyone affected, executives should make decisions in the interest of the stockholders.

Legal Rules To Make Them Do It

How can the legal system make it in the interest of executives to act in the interest of the stockholders? There are three answers.

The first is the legal doctrine of stockholder primacy. In principle the executives of a firm are agents of the stockholders and the stockholders can sue them for doing something, such as overpaying themselves, that reduces the value of the stock. I say “in principle” because, unless the executives are very careless, it is hard to prove that what they did was not a good faith attempt to maximize the value of the stock, which depends not only on profit this month or year but on the flow of profits through the indefinite future.

The second answer is that the board of directors of the firm, which can hire and fire executives, is elected by the stockholders. For that to work to discipline the executives it is not necessary that the executives are not trying to serve the interest of the stockholders. It is only necessary to convince enough stockholders that the present board of directors and the executives they hired are not succeeding in serving the interest of the stockholders, whether because they are corrupt or incompetent, and that another board could hire replacements who would do better.

The problem with this mechanism is the problem with democracy in general: Everyone’s business is nobody’s business. If there are a million shares of stock and I own a hundred of them, my vote has very little effect on who gets elected to the board so it is not worth it for me to spend much time and effort deciding which candidate will do a better job. Figuring out what a company should be doing is not a trivial problem; a random stockholder is unlikely to have the expertise needed to do it. Stockholder democracy is a workable solution to the problem for a closely held corporation where a few stockholders hold most of the stock, much less so for a large corporation with diversified ownership.

The third answer is the takeover bid. One person with access to a lot of money and the skills to recognize that a company is being badly run buys enough stock to let him take over the company, votes out the present board, votes in a board that will do a better job. If he was correct in his judgement the company starts doing better, others observe that, the stock goes up. He sells at a substantial profit and starts looking for another badly run company.

The knowledge that, if the executives currently running a company do a sufficiently bad job of serving the interest of their stockholders as judged by an observer with the ability and incentives to judge how good a job they are doing, the company will be taken over and they will be fired is an incentive for them to do a better job of serving the interests of their stockholders. Takeover bids are a stockholder primacy rule with teeth.

Currently legal rules make takeover bids more difficult by requiring the investor to take a variety of publicly visible actions in the process of increasing the fraction of shares he controls. The earlier his attempt becomes visible the less profitable it will be, since stockholders who expect it to succeed will be unwilling to sell at the initial price. Reducing or eliminating those requirements would increase the degree to which executives find it in their interest to serve the interest of their stockholders, improving the decentralized coordination mechanism on which our lives depend.

[I am ignoring a large number of complications, some of which have been or will be dealt with in other posts, in order to sketch the argument in favor of stockholder primacy]

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1. Or my book Hidden Order: The Economics of Everyday Life.

2. I sketch Coase’s explanation of why firms exists and what determines their size, the equilibrium balance between market and hierarchy, in Brilliant Simplicity under the subhead “Ronald Coase.”

3. It does affect the price at which it can issue more stock. I am considering, for simplicity, a firm that issues stock only initially.