Shareholder primacy is underrated.

Most of Friedman's critics are off the mark

Fifty years ago in a famous New York Times essay, Milton Friedman wrote that “discussions of the “social responsibilities of business” are notable for their analytical looseness and lack of rigor.” With a few noted exceptions, his claim has stood the test of time. 

It has become fashionable for business leaders to attack Friedman’s statement that the only responsibility of a CEO is to “to make as much money as possible” for their shareholders, yet his essay contains real insight that most of his critics miss. 

Some attribute all sorts of myopic corporate behaviours to Friedman’s essay, such as cutting research and investment, yet a share price is a function of all future cash flows. Even if an executive could artificially pump up the share price in the short term at the expense of long-term profitability, he would be failing to maximise long-run profits to shareholders, which is the opposite of what Friedman advocates.

In some cases, his critics unwittingly restate his case. Take a recent Business Insider op-ed, the author quotes Rebecca Henderson, a Harvard economist who criticises Friedman’s theory of shareholder primacy.

“To reverse inequality, companies must embrace stakeholder capitalism, Henderson said. She suggested that doing so could also help a business' profits, contrary to Friedman's argument.”

She gives examples such as granting employees paid leave, investing in energy-efficient light bulbs, and promoting racial justice all leading to higher profitability. Strangely, the reader is told all of these profitable activities are incompatible with Friedman’s imperative to make profits. The author’s policy on cake is pro-having it and pro-eating it.

Underpinning Friedman’s argument is the Smithian idea that a corporate executive’s pursuit of profits for shareholders frequently promotes the interest of stakeholders more effectively than when the executive deliberately sets out to help them.

Stakeholder capitalism’s most thoughtful advocate Alex Edmans identifies a key insight of Friedman: “a company has no comparative advantage in socially responsible actions. $1 spent on a social initiative creates the same value as $1 spent by anyone else.” Would it not be better for a business to return higher dividends and leave shareholders to donate to their preferred charity? Some businesses might have better opportunities available for charitable aims, but is it likely all do?

When 181 CEOs signed up to the Business Roundtable’s recent rejection of shareholder primacy, they agreed to a statement which grants them great leeway with little oversight. There is no guidance on what to do when stakeholders’ interests come into conflict. Steven Kaplan gives the example of GM deciding whether or not “to close a plant producing gasoline cars in Michigan and to open one producing electric cars farther south.”

The CEO can say, “I kept the old plant and employees! The employees and community are happy. I am a great success!” 

Or the CEO can say, “I built the new plant. The environment is happy. The new community is happy. I am a great success!”

You see the problem. The CEO can do almost anything and claim to be creating value. 

In an essay somewhat critical of Friedman’s shareholder primacy view, Samuel Hammond cites an acquaintance who spent decades working in large, publicly traded companies: “I often don’t know what does motivate corporate decisions, but I can assure you it’s not that.”

I suspect the real world impact of Friedman’s view has been overstated. It is common to talk about economics as if it assumes that everyone is a rational utility-maximiser. 

But intention is overrated. It is useful to think about markets as a selection mechanism. Animals in the wild do not intend to maximise their number of offspring, but the ones who do are more likely to have surviving descendants. Managers might not all intend to maximise profits per se, but competition filters out the businesses run by the managers who behave least like rational profit-maximisers. Investment and market share will flow from loss-making to profitable businesses.

Free and open competition is a constraint upon stakeholder capitalism. Any attempt to prioritise stakeholders over shareholders will only survive if competitive pressures are weak, or if the actions increase profits for another reason.

Consider the environment. If a business attempts to reduce pollution beyond what is legally required by the government and demanded by consumers, then they will be trading at a disadvantage compared to less scrupulous competitors. In a competitive market, consumers will go elsewhere and their market share will shrink. If the competitors polluted more than the eco-conscious business did even before their most recent green push, then it could have the unintended consequence of increasing pollution. It ain’t easy being green. Lobbying to change the law to create a level-playing field between polluters and non-polluters by internalising the costs of emissions would be a better approach.

Still, it is perfectly possible that a business which sets out to do good rather than make profit could end up doing the latter better than its competition. Friedman would never presume to know how to run a business better than its CEO. Yet, if you are serious about prioritising stakeholders at the expense of shareholders (i.e. profits), then market competition presents serious difficulties.

There is still a place for business ethics as a form of professional ethics. The philosopher Joseph Heath draws an analogy with legal ethics. A lawyer has an obligation to provide her client with the best possible legal defence. It would be inappropriate for a lawyer to consider the interests of stakeholders in the justice system. But the lawyer still operates outside of obligations of general morality. A lawyer who suspects their client is lying and is guilty is still obligated to provide the best possible defence, even if the result will be an injustice. 

A lawyer’s actions are justified in the context of an institution that produces good outcomes. “The desirable outcome is a product of the interaction between individuals acting in these roles, none of whom are actually seeking that outcome” as Joseph Heath puts it. The defence lawyer ‘promotes an end which was no part of his intention’ to use Smithian terms.

There are constraints on a legal defence, of course. A lawyer cannot threaten witnesses or commit perjury. But, importantly, the constraints are directly related to the adversarial legal system’s ability to achieve the right outcomes.

Markets are similar. Executives play an analogous role. The profit motive is vital to the functioning of competitive markets as an institution that delivers desirable outcomes. Without it there will be no price mechanism and the efficient allocation of goods and services would not be possible. 

Business ethics then should mirror legal ethics. Just as lawyers have a moral responsibility to provide their client with the best possible defence, but are restricted to legal measures only. Executives have a responsibility to make as much money as possible for shareholders, but are restricted to fair and open competition - what Friedman describes as “conforming to the basic rules of the society”. He singles out deception and fraud in particular because they undermine the ability of markets to function. 

Where Friedman falls short is in explicitly setting all the ways executives can undermine the ability of markets to function. One way businesses can go beyond free and open competition is by lobbying to erect new regulatory barriers to entry. Often these can be hard to detect. To the untrained eye, they may even be perceived to be acting responsibly. A tech giant might lobby for stricter restrictions on tackling online harms or improving data protection. But while regulations that impose a fixed cost on business may be easy to spread across millions of sales for a Facebook or a Google, but hobble the efforts of upstart competitors. There is some evidence GDPR has had this effect. On the flipside, when regulations have the potential to restrict their ability to profit from pollution, they ought not to lobby against them.

Ultimately, we should view Friedman’s argument not as an attempt to tell executives how to act, but as a defence of the market system. When someone argues that we need to prioritise all stakeholders not just shareholders, there is an unstated implication that business as usual is bad for stakeholders. Yet, ironically, the rise and success of stakeholder capitalism suggests that in practice there is little conflict between pursuing the goals of shareholders and stakeholders broadly.