Moving from shareholder value maximization to shareholder welfare maximization may be a small step in theory, but it could trigger a leap forward in the way our corporations are run.
In an interesting article on Forbes, Tim Worstall criticizes the interpretation of our latest paper on ProMarket. He claims that the title of the article (“Where Friedman Is Wrong”) is misleading. His argument is based on the fact that Friedman was well aware that “human beings maximize utility, not income” and that “we’re still saying that shareholder interests come first and only for a company, we’re just agreeing, as Friedman would, that those interests are shareholder utility, not money exclusively.”
As authors of the paper (Luigi Zingales is also one of the editors of the ProMarket blog), we feel obliged to intervene and clarify. We agree with Tim Worstall that Friedman believed that people maximize utility, not income. In fact, in his famous 1970 article he writes that the desire of shareholders “generally will be to make as much money as possible.” The “generally” indicates that he recognizes that shareholders sometimes have other objectives. Yet, Friedman concludes that “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits.” Friedman can conclude in this way because he has in mind a world where social activity and profit making activity are completely independent (as is the case for corporate charity). There is no loss of efficiency in letting shareholders decide which charities should be financed. Under this very restrictive assumption Friedman’s conclusion is right. In the more general case, where, for example, undoing pollution is more expensive than curbing it to begin with, Friedman’s conclusion does not follow logically. In this respect Friedman was wrong. Hence, the legitimacy of the title.
We are glad that Worstall thinks that our practical implications are aligned with Friedman’s. We admire Friedman and we have no desire to prove him wrong. What we do want is to correct a diffuse and consequential mistake that is generally made in teaching finance. We looked at the five most cited corporate finance textbooks. Four explicitly mention shareholder value maximization as an objective. None mentions shareholder welfare maximization.
More importantly, we want to correct the mistake that our teaching has produced on the way public corporations are run. The figure below shows the percentage of Dow Jones Index companies that mention value maximization as an objective: Friedman’s rule and MBA teaching had some impact on business practices. It was on the basis of this principle that the board of Wal-Mart opposed the inclusion in the proxy ballot of a shareholders’ proposal aimed at reconsidering the sales of high-capacity magazines, the ones used in mass-shootings. It is on the basis of the “shareholder value” principle that corporate boards and courts of law reject the ability of shareholders to influence corporate policy on important issues that shareholders care about. Moving from shareholder value maximization to shareholder welfare maximization may be a small step in theory, but it could trigger a leap forward in the way our corporations are run.