Capital Matters

Milton Friedman’s Shareholder Primacy Stands the Test of Time and Helps Many Stakeholders 50 Years Later

George W. Bush talks to Rose Friedman as her husband Milton Friedman addresses dignitaries gathered at an event held in his honor at the Eisenhower Executive Building in Washington, D.C., May 9, 2002. (Kevin Lamarque/Reuters)
Joe Biden and CEOs emphasize helping non-shareholder stakeholders, but they ignore how Friedman’s shareholder primacy theory does exactly that.

Exactly 50 years ago this week, Milton Friedman published his now-famous essay A Friedman Doctrine: The Social Responsibility of Business Is to Increase Its Profits, which many, including, last year, the Business Roundtable and, this year, presidential Democratic nominee Joe Biden, decry as harmful to other stakeholders such as a company’s workers and the communities in which they operate, a claim that is difficult to support. Putting shareholders first often operates to the benefit — not the detriment — of other stakeholders.

The denunciation of “shareholder primacy” and adoption of so-called “stakeholder capitalism” by the Business Roundtable (BRT), was recently summarized by the BRT’s president and CEO, Josh Bolten, writing in the Wall Street Journal. The new statement, he explained, was a declaration that “companies should not only serve their shareholders but also deliver value to their customers, invest in employees, deal fairly with suppliers, and support the communities in which they operate.” Perhaps those words could be read as little more than virtue signaling in a competition for customers who are increasingly demanding that companies demonstrate some form of public support for social causes. If so, by making such “stakeholder” statements to retain and help win new socially aware customers, companies are still putting their shareholders first. At the same time, those who worry that even fairly anodyne wording such as this is opening a door that can lead to some very dangerous places won’t have been reassured to read Bolten’s reference in the same article to “short-term shareholders” (time-honored bogeymen) as “a malignant influence on American business — for example, by pressuring companies to forego investments in plants, equipment, research and workforce to meet quarterly financial targets.”

It is also a common fallacy that Friedman’s shareholder primacy theory states that profits must be the sole purpose of a corporation. He recognizes that “employers may have a different objective . . . for example, in the context of a hospital or school” where “the manager of such a corporation will not have money profit as his objective but the rendering of certain services” but “is still the agent of the individuals who own the corporation or establish the eleemosynary institution.” Corporations can still aim to serve non-monetary interests outlined in their shareholder agreements and corporate charters as, indeed, many non-profits and foundations do while maximizing what economists Oliver Hart and Luigi Zingales have referred to as “shareholder welfare.”

But corporate stakeholder statements from the likes of the BRT often overstate what profit-seeking corporations are doing and should be doing to address broader societal objectives. Corporations on average do not give more than 1 percent of their pre-tax profits to charitable causes, according to the Giving USA 2020 Annual Report on Philanthropy (this 1 percent figure has been relatively constant since these reports began). And that is not a bad thing: Private charity should ultimately be the responsibility of individuals in their capacity “as a principal, not an agent,” as Friedman put it.

Contrary to the views of those who argue otherwise, shareholder primacy is not a zero-sum choice. Rather, the corporation that best serves its customers and its workers is often the one that best serves its shareholders. It benefits shareholders if their companies retain the talent they need by rewarding hard-working employees with competitive wages if they are to succeed and attract talent in the labor market. When companies such as Walmart have implemented $15 minimum wages voluntarily rather than as the result of government intervention, they do not do so as an act of charity. Equally, putting the shareholder first often requires the company to treat its customers well, whether by offering high-quality products and services or by competitive pricing or by both. It says something that, according to economist James Bessen, there are more than 50 times as many products at the grocery store today than there were 80 years ago.

By contrast, Friedman argued that when a manager deviates from a company’s shareholder mandate by spending corporate money in pursuit of general social interest, “insofar as his actions lower the wages of some employees, he is spending their money” and “insofar as his actions raise the price to customers, he is spending the customers’ money.”

Shareholder primacy and corporate profit-seeking is often conflated with monopoly and/or abuse of market power that at times (arguably especially right now) stand in the way of this process of forming competitive prices. However, monopoly rent-seeking has no role in Friedman’s framework. He also advocated for competitive markets and low barriers to entry.

Some stakeholder proponents argue that shareholder buybacks that return capital to shareholders come at the expense of longer-term investment; however this view is largely wrong. As research by Cliff Asness, Todd Hazelkorn, and Scott Richardson demonstrates, buyback activity is uncorrelated with a firm’s level of investment. Instead, capital that, in management’s view, cannot be used for productive means is returned to shareholders and largely redeployed to smaller companies, which in turn create jobs and serve new markets.

Advocates of “ESG investing” (in which companies are also measured by the extent to which they live up to certain environmental, social, or governance benchmarks) or other forms of “socially responsible” investing, a notion that also forms part of the “stakeholder capitalism” mosaic, argue that this can be achieved without hurting returns. Indeed, it’s often claimed that it will reduce risk and may often enhance returns. It’s uncertain, to say the least, how well this stands up. Divestment from ESG-unfriendly “sin stocks,” say, those in the energy sector, in theory decreases their stock price and increases their cost of capital today as companies have to work harder in order to attract capital from a smaller pool of investors. Over the longer term, however, this may have the effect of increasing the returns for those who invest in them, assuming the company’s fundamentals (cash flows) remain unchanged by fewer investors holding the “sin stocks.” In looking at these issues, economists Harrison Hong and Marcin Kacperczyk, using data from 1965 to 2006, found that “sin stocks” (e.g., tobacco, alcohol, gambling stocks) outperform non-“sin stocks” in the long run. Another more recent study found that ESG did not immunize stocks during the COVID-19 crash and was negatively associated with returns during the market’s “recovery” period in the second quarter of 2020.

To be clear, I’m not arguing that putting the shareholder first is the answer to all society’s problems. That’s not what companies are set up to do. As Friedman put it, the beauty of a private entity is its clearly defined purpose is to serve its shareholders’ well-defined specialized goals: “The criterion of performance is straightforward, and the persons among whom a voluntary contractual arrangement exists are clearly defined.”

By contrast, trying to harness the resources of a specialized private company’s resources to achieve a general societal goal presents problems that are practical as well as philosophical. Starting with the first, there are, for instance, questions over how such efforts would be coordinated (to take one example, how to determine how much a given company should voluntarily agree to cut carbon emissions). And the efficiency cost is obvious. Rather than each company focusing on what it does best, they would be trying to share in the achievement of a collective goal, which they would not be equally well-equipped to achieve. That’s not what Adam Smith meant by “division of labor,” and the costs, whether strictly financially or in wasted effort, would likely be immense.

Establishing the direction in which society should go is the business of government, not business. When it comes to the environment, for instance, it should be up to voters and their elected governments to decide how to price or otherwise police the externalities that a company can generate. Waiting for corporations to act against the interests of their own shareholders’ welfare is neither the right nor the efficient way to go.

That’s not to say that the private sector cannot help resolve problems identified by the voters. More often, given the right incentives, it will do so more efficiently than government ever could in the long run. For instance, electric-car companies such as Tesla build emission-free cars that reduce global emissions, and pharma companies such as Moderna race to build COVID-19 vaccines but still operate under a mandate to maximize shareholder value.

Adam Smith understood this. By directing that his or her company be run “in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention,” an end, however, that is in the broader interest of society.

Jon Hartley is a master’s student at the Harvard Kennedy School and a Visiting Fellow at the Foundation for Research on Equal Opportunity. He formerly served as a senior policy adviser to the Congressional Joint Economic Committee.

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