When do market forces push firms toward stakeholder goals, rather than just shareholder goals? When do market forces push firms toward ESG goals? When are political solutions to such issues warranted? Eugene F. Fama, winner of the 2013 Nobel Prize for economics, offers thoughts and references to related work.

Editor’s note: To mark the 50-year anniversary of Milton Friedman’s influential NYT piece on the social responsibility of business, we are launching a series of articles on the shareholder-stakeholder debate. Read previous installments here.

Stakeholders versus Shareholders

There is currently much discussion of stakeholder capitalism, the proposition that firms should be run in the interests of all their stakeholders, including workers, and various types of securityholders, and not just shareholders.

My theme((Thanks to Oliver Hart And Luigi Zingales for helpful comments.)) is that contract structures—the contracts negotiated among a firm’s stakeholders—address stakeholder interests. Contract structures are an important ingredient in the survival of firms. In a competitive environment, firms have incentives to negotiate contracts that allow them to deliver the products demanded by customers at the lowest cost. This survival competition benefits consumers, and with freely negotiated contracts, it benefits stakeholders.

I focus on internal stakeholders. A firm’s suppliers might be included among its stakeholders, but supplier interests are covered by suppliers. A firm’s customers might be included among its stakeholders, but in a competitive environment, satisfying customers is a first-order survival consideration for firms. If the firm is a monopsonist or a monopolist, however, these conclusions might change.

Stakeholder capitalism is not a new concept. It can be viewed as an application of the Coase Theorem. In a world where contracts are costlessly written and enforced, the optimal decision rule for a firm is to maximize the combined wealth of its internal stakeholders. Contracts can then be used to split the wealth among stakeholders.

Note that I take the goal to be max wealth for internal stakeholders rather than max welfare. In my view, the divergent tastes of stakeholders for different dimensions of welfare mean that a more general max welfare rule is subject to contract costs that typically make it an inefficient decision rule. This is a central issue I will discuss in detail.

When contracts are not costlessly written and enforced, contract costs can explain how max shareholder wealth can displace max stakeholder wealth as a firm’s optimal decision rule. In a competitive environment, the survival of firms requires that they cover their costs, including contract costs. If all stakeholders have rights to influence the firm’s decisions, they are unlikely to agree about which decisions maximize combined wealth, and they are unlikely to agree about how combined wealth is split among stakeholders. In short, contract costs are likely to be high.

Building on Jensen and Meckling (1976) and Fama and Jensen (1983a, 1983b), Fama (1990) argues that the common solution to this contract cost problem is a contract structure in which almost all stakeholders negotiate fixed payoffs (basically, forms of debt), and shareholders bear the residual risk of net cashflows —revenues minus costs. (This is why shareholders are called residual risk bearers.) In exchange for fixed payoff contracts for other stakeholders, shareholders get most of the rights with respect to decisions that affect net cashflows. Given the contrast costs of more complicated multidimensional decision rules (like max shareholder welfare), the optimal decision rule is max shareholder wealth.

Fixed payoff contracts for other stakeholders do not mean the promised payoffs are riskless. Fixed payoffs of all types are negotiated to reflect their risks much in the way debt securities (bonds) are priced to reflect the risks of their fixed promised payoffs.

Fixed payoff contracts have details that vary from one group of stakeholders to another. To a large extent, the details center on controlling the risks of fixed payoffs, how payoff risks will be monitored, and what happens if promised payoffs are not met. Since contracts are not costlessly written and enforced, this doesn’t rule out opportunistic behavior by shareholders. But the possibility of opportunist behavior is a dimension of default risk that should be reflected in the size of fixed promised payoffs. Thus, contract costs permitting, shareholders have incentives to write contracts that limit their opportunistic behavior. 

Another discipline comes from contract renegotiation. Fixed payoff contracts are often subject to periodic (for example, annual) negotiation. The prospect of renegotiation limits opportunistic behavior since it is likely to be penalized by higher fixed payoffs in future contracts. Fama (1980) calls this “ex post settling up.”   

The bottom line is that with freedom to contract, the contract structures we observe are bottom-up competitive solutions to the problem of maximizing stakeholder welfare in a world where contracts are not costlessly written and enforced. For most firms, the winning contract structure involves fixed promised payoffs for most stakeholders, with residual risk largely borne by shareholders, who as a result have most of the decision rights. There are, however, differences in the details for different types of organizations (discussed in Fama and Jensen 1983a, 1983b).

The competition among contract structures to deliver the products demanded by customers at the lowest cost is ongoing. My preference is to let competition produce adaptations, rather than impose top-down changes with catchy names like stakeholder capitalism that are likely rife with unintended consequences.         

“My preference is to let competition produce adaptations, rather than impose top-down changes with catchy names like stakeholder capitalism that are likely rife with unintended consequences.”

ESG (Environmental, Social, and Governance)

The G (governance) in ESG is easy to address. A firm’s governance structure is part of its contract structure. In a competitive environment, the firm has incentives to choose a governance structure that contributes to allowing it to deliver products demanded by customers at the lowest cost. This issue is discussed in Fama and Jensen (1983a, 1983b). Constraints on governance choices (for example, laws that specify the racial or gender mix of boards of directors) are likely to introduce inefficiencies that, if forced on all producers, are in the end paid for by consumers.

E&S (environmental and social) issues are more complicated. If environmental and social goals enter consumer utility functions, they provide incentives for firms to provide products that lean toward these goals. For example, if many consumers prefer the more expensive meat of free-range chickens and cows to the meat of their caged brethren, firms will provide free-range meat without Government incentives. Consumers vote via their purchase decisions, and the economy produces the right amount of free-range meat. In this way, markets provide solutions to some E&S problems.

Asset markets can help accommodate E&S issues. Most asset pricing models assume investors are only concerned with the wealth generated by their investments. Fama and French (2007) present a model in which investors also have tastes for assets as consumption goods. The tastes might include E&S actions by the firms in which they invest. In 2007, E&S considerations, labelled socially responsible investing, started to show up in the asset management industry. There is now a wide range of E&S investment products.

On the asset pricing side, what are the costs and benefits to firms in choosing products and production techniques oriented toward E&S goals? If some investors value the E&S actions of firms, then given net cashflows, a switch from indifference to E&S virtue is rewarded via higher share prices, which imply lower expected returns and costs of capital. Lower costs of capital help firms in the competition for survival. But adopting E&S goals is also likely to raise production costs, which leans against the benefit of lower costs of capital. Note also that lower costs of capital for E&S accredited firms mean that for E&S investors, virtue is its own reward since investors get lower expected returns from the shares of virtuous firms.

Accommodating E&S issues is a step toward a more general decision rule, which is max shareholder welfare, not just max shareholder wealth. Unlike wealth, welfare has multiple dimensions, and tastes for different dimensions are likely to vary across shareholders. Even if all a firm’s investors agree that more is better than less (or vice versa) on different dimensions, they are unlikely to agree on tradeoffs. 

For example, an E&S virtuous firm may commit to transfer half of annual profits that would otherwise accrue to shareholders to outside groups that fight for E&S issues. For some investors with tastes for E&S actions, 50 percent may be too much, and for others it is too little. There is also likely to be disagreement on how the 50 percent is split among different E and different S actions.

How to resolve this problem? Hart and Zingales (2017) argue that since shareholders have the decision rights, a shareholder vote is a possibility. But choosing the specifics of a question may itself be a difficult problem. Moreover, a vote implies winners and losers, and the possibility of unexpected actions that may violate the E&S tastes of some investors is likely to make investors less willing to bear the costs of E&S commitments by firms.

This discussion takes us back to the initial discussion of how contract costs affect the contract structures of firms. The conclusion there is that the costs of writing and enforcing contracts among stakeholders with divergent tastes and interests typically lead to a contract structure in which most stakeholders have fixed promised payoffs, and residual risk is largely borne by shareholders, who as a result get most decision rights. Pulling the curtains aside, the ESG movement argues that the resulting decision rule should be max shareholder welfare, not max shareholder wealth. But that puts us in the quagmire of satisfying the divergent tastes and interests of different shareholders—a multiple dimension problem that implies high contracting costs. The max shareholder wealth rule is a single dimension alternative with low contract costs relative to max shareholder welfare.

ESG and Externalities 

One impetus for the ESG movement is the judgment that the actions of firms produce externalities that are ignored by the max shareholder wealth rule. 

For example, suppose there are two ways to produce a product. The cheap way produces pollution that costs the firm nothing. The expensive way controls pollution but at some cost to the firm. If consumers are indifferent to pollution, dirty producers drive out clean producers (Shleifer 2004). But if some consumers value less pollution, or can be convinced by E&S arguments to value less pollution, they can vote for less by paying more for the version of the product produced cleanly at higher cost. The end result is the mix of clean and dirty products that consumers vote for with their purchases. It seems that a market solution to this ESG problem works—but not necessarily and probably only partially.

Thus, suppose all consumers care about pollution, and dirty producers offer the same products as clean producers but at lower prices. Despite their distaste for pollution, some consumers are likely to choose the products of dirty producers because they perceive that their individual choices have little effect on the amount of pollution. In other words, there is a coordination problem: everybody would pay more for the products of clean producers if they could be convinced that other consumers would not cheat.

A potential solution is to use the democratic process to control dirty production via regulation. But the Government-imposed solution is not likely to be optimal since there are surely tradeoffs of costs for benefits that change with the amount of pollution, and the tradeoffs change with the evolution of production technology. In the end, imperfect though it may be, E&S activism to shape the tastes of consumers and investors may be a more effective route than regulation.

The coordination problem discussed above is a type of externality. In general, externalities pose problems that are not amenable to complete solutions from individual firms. For example, putting aside coordination problems (consumer cheating), suppose all consumers value and are willing to pay for less pollution, but all consumers don’t buy all products. (For example, most men don’t buy lipstick.) In making their pollution decisions, firms weigh benefits to them versus costs to them of producing with less pollution. But this likely means they ignore the benefits of less pollution to consumers who don’t buy their products.

It is difficult to find activities free of externalities. For example, candy bars and sugared drinks are potentially toxic for consumers with a tendency towards diabetes. One might argue that personal freedom demands that such consumers eat and drink what they please since they bear the costs and benefits. But they don’t bear all the costs if their health care is in part paid for by other people through higher premiums for health insurance or socialized healthcare. Smoking and hard drugs are similar examples.

When pressured, the political process might address such externalities, but the solution is likely to be clumsy. Activism that induces consumers and investors to value E&S friendly products may be a better (though imperfect) alternative. On the plus side, activism that affects the behavior of consumers and investors is a market-oriented approach that may adjust more flexibly to unpredicted negative outcomes than political solutions.

ESG activism is likely to accomplish more by working through consumer tastes than by working through investor tastes. Each consumer can react to each ESG action with respect to a specific product according to her/his tastes. But an investor is committed to the set of ESG actions of a firm during the period a security is held. Given the divergent tastes of investors, commitment to the somewhat unpredictable ESG actions of firms looks like a black box with uncertain welfare payoffs. This is likely even when investors are committed to ESG goals, but to different degrees and with different tradeoffs among the multiple dimensions of E, S, and G. The result is likely to be limited participation in ESG investment, even by investors committed to ESG action. For most investors, the single dimension max shareholder value rule is likely to be more attractive.   


My general argument is that market forces address the issues raised by the stakeholder capitalism and ESG movements. Market solutions are not perfect, especially in the presence of externalities, but no solutions are perfect when contracts are not costlessly written and enforced.


  • Fama, Eugene F., 1980, Agency Problems and the Theory of the Firms, Journal of Political Economy 88, 288-307.     
  • Fama, Eugene F., 1990, Contract Costs and Financing Decisions, Journal of Business 63, S71-S91.     
  • Fama, Eugene F. and Kenneth R. French, 2007, Disagreement, Tastes and Asset Prices, Journal of Financial Economics 83, 667-689.      
  • Fama, Eugene F. and Michael C. Jensen, 1983a, Separation of Ownership and Control, Journal of Law and Economics 26, 301-325.     
  • Fama, Eugene F. and Michael C. Jensen, 1983b, Agency Problems and Residual Claims, Journal of Law and Economics 26, 327-349.
  • Hart, Oliver, and Luigi Zingales, 2017, Companies Should Maximize Shareholder Welfare Not Market Value, Journal of Law, Finance, and Accounting 2, 247-274.
  • Jensen, Michael C, and William H. Meckling, 1976, Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, Journal of Financial Economics 3, 306-360.
  • Shleifer, Andrei, 2004, Does Competition Destroy Ethical Behavior? American Economic Review 94 , 414-418.