Shareholders Don’t Always Want to Maximize Shareholder Value

Oliver Hart, winner of the 2016 Nobel Prize for economics, reflects on how the world has changed since Milton Friedman published his famous essay on the social responsibility of corporations.

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. The following is based on a talk Oliver Hart gave during the Stigler Center’s 2020 Political Economy of Finance conference.

Let me start by saying that Friedman’s article obviously has had a huge impact. I think there are some things in it that stand up very well 50 years later, others a bit less so.

I agree with Friedman that most companies are set up to act on behalf of shareholders—shareholders have the votes, so I agree with him about that. I don’t agree with him that it follows that companies should maximize profits or shareholder value. Why do I think that? Well, because shareholders may themselves not be interested just in the bottom line.

My view is that companies should find out what shareholders want and should pursue that goal, and that is not always value maximization. It’s not even always long-run value maximization.

Let’s take an example: climate change. In an ideal world, national governments would get together and agree on a carbon tax, and most economists think that’s the way to deal with climate change: you would have a worldwide carbon tax. We’re very, very far away from that.

Given that there are national and international political failures, what should people do? What can they do? Well, individuals care about the environment. They don’t just spend all their time trying to improve political decisions: they do things on their own. Individuals might install solar panels, or they might buy electric cars. If individuals are willing to do things on their own behalf because governments have failed to do things, then why wouldn’t they want the companies they own to also do things?

Just think about reducing your carbon footprint. I’ve given you examples of how an individual can do that, but those examples are sort of small potatoes. It can be much more effective for companies to reduce their carbon footprint, rather than have individuals do it.

This is where I think Friedman didn’t get it right, because there are some social activities in which companies have a comparative advantage relative to individuals, given that governments aren’t getting things fully right.

An example I think Friedman was right about was charitable contributions. This is a famous example. I don’t think companies have a comparative advantage in giving to charity. It would be much better for them to take the money they would have given to charity, hand it to shareholders, and let each shareholder decide how much to give to his or her favorite charity.

But when it comes to things like the carbon footprint, companies are actually in a much better position to help with climate change than individuals. And if you ask the individual shareholders: Would you be willing to give up some profit, some money, some long-run shareholder value, and in return, your company will become greener? Many shareholders, the very same ones who install solar panels or buy electric cars, might well say “yes.” And in that case, if a majority feels that way, I think the company should do the green thing.

By the way, it’s not just shareholders who may be willing to give up money for companies to do socially responsible things. It may also be consumers and workers.

Let me now turn to what mechanisms are available for influencing companies. If you accept, like me, that companies shouldn’t necessarily ignore social responsibility, then how can people influence them? There are two main mechanisms: exit or voice (to use Hirschman’s terminology).

What is exit? Exit refers to things like shareholders divesting from companies, or consumers boycotting their product, or workers refusing to work for “dirty” companies. Examples of voice are shareholders using their votes, or other ways, to engage with management and force company change.

In a recent paper with Eleonora Broccardo and Luigi Zingales, we compare exit and voice theoretically, and we find that voice is surprisingly good relative to exit.

Let me try to explain why: Consider a company that could spend $100 to become greener, and that would improve the environment by $120. So the value of being greener to the world is $120, and it costs the company $100 to do it. Economists would say: Well, that’s a good thing for the company to do.

Now, imagine that shareholders were asked to vote on whether the company should do that. And let’s suppose they’re very well-diversified, so they’ve invested in lots of companies and each shareholder owns just a very little piece of this company. When they’re considering which way to vote, they’ll think to themselves: Well, if my company becomes greener, they have to pay $100, so profits will go down by $100, the share price will go down in total by $100. But as a very small shareholder, the capital loss I will experience will be extremely small. It’ll be my share of that $100, and that’s going to be almost nothing, a cent or something.

On the other hand, when I think about the impact of this change, if I vote for it and if it goes through, then it’s going to hurt shareholders as a whole by $100, but it’s going to improve the world by $120. So if I put on my social hat, that’s plus $20. So what will I do if I’m socially responsible? We model this in our paper. What will the shareholder do? He or she will put 100 percent weight on their capital loss and some weight on this plus $20. Because the capital loss is negligible, since they have a negligible shareholding in the company, even though they’re putting 100 percent weight on that, it’s actually the other stuff that’s going to dominate. The weight they put on that plus $20, even if it’s a small weight, that’s going to beat the one-cent capital loss that they experienced. So they’re actually going to vote for installing the clean technology, for saving the environment. They’re going to do the socially correct thing.

This turns out to actually be our general result for the case where everyone’s very well diversified. It wouldn’t be true if we had a large shareholder for whom the capital loss might loom much larger. So that’s why voice actually does surprisingly well.

Now, we compare that strategy of trying to change what the company does to the indirect exit strategy. Let’s stick with shareholders and consider their exit strategy, which would be to divest: if you’re a shareholder who would like your company to be greener, what you do is you say, “I don’t like this company, I’m going to sell my shares, I’m going to get out. That’s how I’m going to show my disapproval of what they’re doing right now.”

That is a very indirect mechanism for achieving change, because the way it works is that you divest, and maybe some other people like you divest, and the share price goes down, and the idea would be that the company doesn’t like a lower share price so it might respond. If it goes down enough, the company will say, “Oh, this isn’t good.” And we’ve heard CEOs are often paid according to share prices, so they might say, “Perhaps we should carry out this investment, become green, and that’s the way to get the share price up again.”

The problem with that is that even though some people might be willing to divest because they feel very strongly about it, other people who are either purely selfish or only slightly socially responsible might think, “Wow, these prices going down. This is a bargain. Now I can make money, large amounts of money, by buying these discounted shares,” They’ll do that and drive the price up again. So the price effect from divestment can be really quite small.

The point I would like to get across is there’s a very different calculation in the vote, where you have this negligible capital loss, and you’re comparing that with the social impact, and the calculation of an investor who has the opportunity to buy discounted shares and make money. That person has to be very socially responsible not to do that, whereas in the vote you only have to be slightly socially responsible to vote green.

I’d recommend reading the paper, because there’s a little more to our analysis than what I’m saying, but this the broad outline.

What does one make of these results? What does one conclude? One conclusion is that a lot of government policy and regulation seems to be pushing in the wrong direction. If you look at the SEC policy over the years, it has been to make voice much more difficult. It’s made it much harder for shareholders to express their views.

If you take our analysis seriously, you would say that’s really the wrong way to go. You should be trying to make the expression of shareholder views easier. Just to mention a very recent example which many people will be aware of, the US Labor Department is planning to make it impossible for people running private pension funds to take ESG factors into account, regardless of what the people investing their money with them might want. The pension fund managers apparently can’t even consult the investors about what they would like. Instead, according to this Labor Department proposal, they must focus 100 percent on shareholder value. That just seems to me to make no sense at all.

The world has changed in the last 50 years in many, many ways. Certainly, environmental concerns have become more serious and more salient, relative to the time when Friedman published his article. But another thing that has changed, I think, is that we’ve understood the limitations of some of his arguments.