Rekindling the Stakeholder-Shareholder Debate

by: Alpha Author

The Economist ran an article last week reviving the decades-old debate between models of shareholder wealth maximization and stakeholder wealth maximization (see A New Idolatry).

The basic idea behind the shareholder wealth maximization model is that a firm’s sole purpose is to maximize shareholder value (i.e., share price). The stakeholder view offers a different (although not necessarily contradictory) perspective.

According to stakeholder theory, the aim of the firm is to maximize value by taking the concerns of all its stakeholders, not simply its shareholders, into consideration. That is, firms ought to incorporate stakeholder – shareholder, supplier, customer, employee, community, and any other constituency with a “stake” in the firm – interests into their decision calculus, thereby generating value not just for shareholders, but also for society at large. It shifts the maximization problem from one of individual utility maximization (in the interest of shareholders) toward one of joint utility maximization (balancing the disparate concerns of various interested parties). Wikipedia provides a and brief overview of stakeholder theory for anyone interested in reading more (see Stakeholder Theory).

Oh yeah, back to The Economist article:

The economic crisis has revived the old debate about whether firms should focus more on their shareholders, their customers, or their workers.

[The shareholder maximization model] has dominated American business for the past 25 years, and was spreading rapidly around the world until the financial crisis hit, calling its wisdom into question.

…Roger Martin, dean of the University of Toronto’s Rotman School of Management, charts the rise of what he calls the “tragically flawed premise” that firms should focus on maximising shareholder value, and argues that “it is time we abandoned it.” The obsession with shareholder value began in 1976, he says, when Michael Jensen and William Meckling, two economists, published an article, “Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure”, which argued that the owners of companies were getting short shift from professional managers. The most cited academic article about business to this day, it inspired a seemingly irresistible movement to get managers to focus on value for shareholders. Converts to the creed had little time for other “stakeholders” …[and] American and British value-maximisers reserved particular disdain for the “stakeholder capitalism” practised in continental Europe.

I have long been a proponent of a more stakeholder-oriented approach. However, I admit that it might be a bit difficult to advocate for European versions of “stakeholder capitalism” given the recent problems in the PIIGS nations.

That notwithstanding, I think the shareholder-stakeholder divide speaks to one of the fundamental criticisms of the field of financial economics, and its dogged adherence to the shareholder wealth maximization paradigm (see The Future of Financial Economics and Part Deux for criticisms of that approach). Back in March of 2009 I wrote:

…I have had more than a few conversations with prominent economists and sociologists about the social implications of a dogmatic adherence to models of shareholder wealth maximization. Unfortunately, if incentives are structured such that they exclusively reward shareholders (and in some cases, managers) at the expense of other constituents (stakeholders), this could lead to suboptimal social outcomes.

Shareholder maximization vs. Stakeholder maximization has been a topic of considerable debate in the strategy literature over the past 15-20 years. And given the social costs of this financial crisis, I would not be surprised to see the Stakeholder view gain more traction in the years to come.

Although I have been an advocate of a more stakeholder-oriented approach, this is not to say that there are not valid criticisms that can be leveled at stakeholder theory. The shareholder maximization approach is appealing precisely because profitability and share price are quantifiable, and easily measured. However, concepts from stakeholder theory defy quantification in a conventional sense. It’s not always clear which are the right stakeholders to pay attention to, and even if you can identify the appropriate stakeholder set, how do you weight their interests accordingly? In addition, how do you quantify, for example, when firms are effectively meeting the needs of their local communities, and what those needs are to begin with?

Admittedly, the stakeholder view of the firm is still in its infancy, but given its broader social implications, and in the wake of the financial crisis, I think it is well worth the effort to try to advance the field.

In recent years I have worked with Michael Barnett of Oxford on ways to better quantify stakeholder performance, and on how to bridge the stakeholder-shareholder divide. Other scholars in strategy, management, and finance are likewise devoting increasing attention to this topic. I am therefore hopeful that we, as a field of organizational scholars, will come to some new understanding in this respect.

Of course, the Economist article that I quoted does not break any particularly new ground in this respect; nevertheless, I am glad that folks in the mainstream media are finally starting to pick up on the shareholder-stakeholder debate. I am convinced that it remains an important one, and the truth is: It is a debate well worth having.

Disclosure: No positions