When the ancient Greek philosophers such as Socrates, Plato, and Aristotle wanted to know what was “good” they appealed to the function or purpose of a thing. For example, a good strategy is one that wins, or a a good racehorse is one that is fast. Using the Greek method, we will try to answer the question “what is a good corporation?” by first answering what is the function or purpose of the corporation. There are two dominant theories of the purpose of the corporation. The first of these is attributed to Milton Friedman.
Milton Friedman’s Theory
Friedman, a Nobel prize winning economist, offers one of the most influential accounts of the purpose of the corporation. For Friedman, the purpose of the corporation is to make a profit for stockholders. In other words, corporate managers are bound to make decisions which maximize the profit of the stockholder. The only limiting condition on these decisions is that managers must “obey the rules of the game.” He offers three arguments in support of this theory:
Stockholders own the corporation.
As owners they are entitled to the profits. Managers are hired to promote the interests of stockholders. For management to place any other interests ahead of the stockholders is to violate their obligation to the stockholders. For example, a corporate manager who donates profits to charity is violating his duty to place stockholders’ interests first. Profits should go to stockholders and then if stockholders wish to donate to a charity that is the stockholders’ right, not the managers.
Stockholders are contractually entitled to the profits of a corporation.
Just as employees are paid a wage for their work, communities are paid through taxes, and contractors are paid for their services, the stockholders are entitled to the profits for their investment. Employees, contractors, communities, and stockholders are all participants in an agreement whereby each provides something and each participant is then reciprocally entitled to something. Stockholders undertake the risk of providing capital in exchange for the benefit of any profits that are made by the corporation.
This corporate arrangement promotes economic and political freedom.
In addition to the above reasons why the purpose of the corporation is to provide profits to stockholders, Friedman offers a utilitarian argument for why this system is beneficial. This system represents voluntary contractually arrangements which maximize economic freedom. One consequence of maximizing economic freedom is the maximization of political freedom. In other words, by sticking to voluntary contractual arrangement (as opposed to requiring shareholders to give up profit involuntarily for “the good” of others) we are promoting a system that promotes freedom. Friedman points out that in a capitalist system (a system based upon voluntary contracts) with an emphasis on the ability to produce, people’s political views become irrelevant. In addition, capitalism promotes diverse political viewpoints because, for example, for profit media can only maximize profits by appealing to a broad range of people.
The above argument may be overstated, but certainly there is a link between free market capitalism and a free society. It is probably less the case that viewing corporations as profit maximizers for shareholders is a social good, than to allow corporations to use shareholder monies involuntarily (by donating to charity for instance) leads to a social evil in the name of “social responsibility”. Friedman attributes any talk about the “social responsibility” of business to promoters of socialism, which undermines free societies. Specifically, talk of social responsibility in business is directed at corporate executives, who are employees of the corporation charged with protecting the interests of stockholders. Of course executives may have social responsibilities outside of the job (as any other person may have in society) but this is not what people mean when they talk about socially responsible businesses. They mean that the executive, in virtue of his job, has responsibilities to society such as reducing pollution, providing jobs for the unemployed, caring for workers, ensuring low prices for the community, etc. In each case the executive is asked to spend other people’s money for the common good of society. This is not what an executive is hired to do, nor should such political questions of the environment, the unemployed, or care for those in need be put in the hands of executives. To place executives in this position is to force them to make political decisions that are best made by elected officials. One way of avoiding this consequence, Friedman claims, is by upholding the voluntary contract in which corporations act to maximize shareholder profit in exchange for their investment.
Friedman also argues against “social responsibility” claiming that any action of an executive which costs shareholders, workers, or consumers money to promote the social good is equivalent to the imposition of a tax. In other words, to pay for a corporate donation to charity either 1) shareholders profits are cut 2) labor salaries are reduced or not increased or 3) product prices are increased. Do we want corporate executives to weigh cuts in employee salaries, lower investor returns, and higher consumer prices against the social good? Or, do we strictly hold the free market position that requires executives to ensure a profit for shareholders (which in a competitive market is often best accomplished by keeping prices down and workers happy)? Anyone who argues for charging executives with the responsibility for making these decisions is not only arguing for socialism, but is attempting to circumvent the democratic process of petitioning government to make these decisions. The ideal free market is entirely voluntary such that no one coerces anyone else. To impose social responsibility on executives is to ensure that someone is coerced into paying for things against their will. We can only ensure a voluntary free market by stating the purpose of the corporation is to protect the interests of stockholders.
Now that we have a basic grasp of Friedman’s theory we can examine some objections to his account of the corporation.
There have been several criticisms of Friedman’s view. They take two general forms. First, there are direct rebuttals to Friedman’s arguments. Second, there are criticisms against Friedman external to his arguments. We will explore a few of each. We begin with rebuttal arguments to Friedman’s three claims:
Direct Rebuttals to Friedman
A direct rebuttal is an attempt to discount the claims presented by the other side in an argument. Direct rebuttals are the strongest objections to an argument because if the rebuttal succeeds on all counts there is no reason to accept the initial argument (in this instance, Friedman’s view). However, it is always wise to go beyond a direct rebuttal and to offer other objections (external objections) to an argument, just in case the direct rebuttal is not persuasive. We shall offer some external objections shortly, here is the direct rebuttal to Friedman.
Stockholders own the corporation.
Opponents rebut this claim by arguing that shareholders are not “owners” in the sense of traditional property owners as shareholders have no claim on any company assets or access to company facilities like a traditional owner would have. For example, my owning 50 shares of Pespi stock doesn’t allow me in virtue of being a shareholder to pickup free cases of pop from the plant. As a result Friedman’s argument that ownership entitles a special obligation of management is not as strong as it first appears. In other words, while stockholders “own a piece of the rock” it does not follow from this ownership that stockholder interests always have priority over or trump competing obligations and the interests of others. No special relationship between stockholders and managers is generated in virtue of stock ownership.
Stockholders are contractually entitled to the profits of a corporation.
This argument can be rebutted by holding that shareholders do not have an explicit contract with managers that binds managers to promote shareholder interests. Absent an explicit contract, Friedman’s second argument must be based on an implied contract. Yet, when you buy stock who are you contracting with since most people buy stocks from other people who own stocks and not the company itself? In other words, buying stocks only implies that if the company makes a profit, you will receive some share of that profit. This is a far cry from obligating managers to maximize stockholder profits. This more limited view is further supported by the fact that company managers and shareholders have no direct contact, managers are not under control of shareholders, and shareholders are not represented by managers. The task of management is to promote the company’s interest (which includes shareholders as well as employees and others). In promoting the company’s interest managers may find a need to improve the company’s image through charitable donations, to increase shareholder dividends, or to spend more resources on worker training, salaries, or benefits.
This corporate arrangement promotes economic and political freedom.
If there is a case to be made for making managers beholden to stockholder interests, it is not found in an explicit or an implied contract, nor is it found by equating a stockholder to an owner. This does leave open the possibility that making managers beholden to stockholder interests is in the best interest of society because this arrangement best promotes economic and political freedom. In other words, the institutional structure of corporations acting predominantly for stockholders may be the best overall public policy. This way of thinking adopts a utilitarian argument for a Friedman like theory of the corporation. Yet, many have rebutted such a position by offering (as we will see in the next section) a utilitarian argument for the opposite viewpoint–that by serving the interests of other affected parties (what many refer to as “stakeholders”) everyone is far better off than by serving only shareholders’ interests. Though it is possible that utilitarian arguments may be used to support Friedman’s case, the fact that Friedman said so little about them implies that utilitarian arguments may not provide sufficient support for his position. At a minimum, Friedman may be correct that his system promotes freedom. However, this claim alone is not sufficiently strong as it does not demonstrate that his system is the only one to promote these ends. The advancement of economic and political freedom might occur under an alternative system that also promotes the needs of others (workers, for instance) while yielding even greater results than Friedman’s system.
Thought Question: Shareholder Protections?
Recent corporate scandals such as Enron have demonstrated how vulnerable shareholders are to corrupt corporate managers who show no concern for shareholder interests. Some have used this vulnerability as an argument for increasing shareholder power, or in Friedman’s language, binding management to the interests of stockholders. Despite these scandals, others hold that shareholders do not need a strong tie to managers to protect their interests. because shareholder interests are protected by:
1. The ability to elect boards of directors and vote on shareholder resolutions.
2. The ability to sell a bad stock where other stakeholders cannot divest themselves so easily.
3. Shareholders are often diversified such that managers are actually have more stake in the company success than a shareholder.
This third point has increasing force as the modern shareholder owns very little of a particular stock and in many cases is unaware of that a stock is part of a mutual fund. Still, one question worth asking is: Do we need more shareholder protections than the three described above? If so, what additional protections?
External Objections to Friedman
In addition to the direct response to Friedman, there are several external arguments against his position. Two of them are:
Friedman’s view justifies all sorts of immoral (or illegal) behaviors in the name of profit maximization.
Of course Friedman does declare that businesses must operate “within the rules of the game” and engage in “open and free competition without deception or fraud.” But what does this qualification actually entail? Friedman does not provide an account of either “the rules of the game” or what constitutes “deception or fraud.” In the absence of Friedman’s own account, some “Friedmanites” have argued in favor of things such as deceptive advertisement and strong government lobbying to ensure that the laws benefit your business. Others have interpreted Friedman such that the rules of business are like the rules of poker where some things (such as deceptions) that are generally immoral are perfectly acceptable “game” tactics.
Friedman’s view perpetuates improper motivations.
Some claim that Friedman’s view justifies the using of employees, customers, and suppliers in any way that generates profit. If profit can be increased by wage cuts, layoffs, plant closings, etc., then that is what a manager should do. The only possible time when actions should be taken to benefit employees, communities, or charities is when doing so is in some way a benefit to the stockholder. For instance, higher salaries to motivate higher productivity, or charity to promote a good public image. The criticism here is that the motive for these “good” actions is self-interest rather than duty (as Kant requires) or compassion (an Aristotelian virtue) or even the greater good of all (the utilitarian’s goal). Friedman’s view specifically bars business from acting out of a sense of duty, compassion, or the good of all by restricting motives of managers to the promoting of shareholder profits.
Now that we have examined some of the arguments against Friedman’s position, let us look at its global implications before moving on to an alternative account of the purpose of a corporation.
Part 4: Global Business Implications & Beyond
Friedman’s View & Global Business
Friedman’s view is very common in the United States, yet it is not strictly upheld in U.S. law and is less influential worldwide. Although Friedman declares that managers are required to maximize stockholder profits, U.S. law certainly does not require this business focus. In addition, several states have passed laws explicitly permitting managers to take into account the interests of other stakeholders (workers, communities, etc.) in decision making. The London Stock Exchange goes even further by requiring that every company listed on its index consider environmental factors when making business decisions. This absence of an explicit legal mandate however, does not mean that U.S. law is completely silent regarding the priority managers should give the interests of stockholders. In fact, as we see in the case of Dodge v. Ford, the court found that Ford could not withhold dividend payments to shareholders to “benefit mankind at the expense of others.” It is clear, that the law does uphold some managerial responsibility to shareholders. Still, this responsibility is not absolute nor is it necessarily dominant. For instance, the court in Smith v. Barlow upheld the managers right to fund private colleges at the expense of shareholders profits.
Beyond Friedman?
We should keep in mind that a rejection of Friedman’s view is not a rejection of the idea that corporations should seek a profit or that shareholders are not entitled to profit from their investment. A rejection of Friedman might only require that in addition to making a profit for stockholders corporations have other obligations to society or that the interests of other groups must be balanced against maximizing shareholder profits. In other words, a rejection of Friedman is an acceptance that there are other stakeholders who deserve consideration in corporate decision making besides just stockholders.
In summation, there are at least two differences between a Friedmanite and a non-Friedmanite. First, a Friedmanite only considers the interests of stockholders where a non-Friedmanite considers the interests of other “stakeholders” as well as stockholders. Second, both groups may decide to take good care of employees and provide charity, but the non-Friedmanite takes these actions because it is the right thing to do whereas the Friedmanite acts because these goals are perceived to be of benefit to stockholders. The textbook cites two examples of how both groups could act identically but for different reasons.
In Minneapolis & St. Paul, MN, Target stores have a competitive advantage over Wal-Mart because of Target’s reputation for charitable giving.
When the Dayton Hudson Corporation was faced with a hostile takeover, the Minnesota Legislature intervened to protect Dayton Hudson on the grounds that it was a good corporate citizen.
In both of these cases, a Friedmanite could defend charitable giving on the grounds that it came back to benefit the company whereas a non-Friedmanite would defend charitable giving on the grounds that it was the right thing to do.
Even if we do reject Friedman’s theory of the purpose of the corporation, we still need to articulate an alternative theory. In the next section we will explore the primary alternative to Friedman. This theory is known as the stakeholder theory.
Part 5: The Stakeholder Theory
One alternative to Friedman’s view of the corporation is the “stakeholder theory,” which holds that in addition to stockholders, managers have obligations to other stakeholders such as suppliers, customers, employees, and the local community. Each of these groups has a stake in the firm and therefore each of them deserve consideration over and above how they might further stockholders’ interests. United States law already places various constraints on management. These laws range from requiring management to inform the public, obey environmental legislation, allow employee unions, and even a case law requiring company owned towns to uphold the constitutional rights of people living there. Some of these laws were designed to force businesses into protecting the stake of particular groups, other laws were designed to safeguard the overall economic good. For instance, laws encouraging competition and preventing monopolies are constraints that compel managers to consider the interests of the common economic good rather than simply the economic prosperity of their stockholders.
What is a stakeholder? There are two potential definitions of a stakeholder. The narrow-definition is any group who is vital to the survival and success of the corporation. At a minimum this would include employees as well as stockholders and perhaps other groups as well. The wide-definition includes includes any group or individual who benefits from or is harmed by corporate actions. The wide-definition then holds that the ability to benefit or suffer harm grants a stake in the decision-making process that should not be ignored by management. This ability to benefit or suffer harm is what we refer to as business externalities, or the effects upon third parties of doing business. For instance, if A and B make a deal that imposes a cost on C then C, in virtue of this externality, should be a stakeholder in the deal between A and B. Pollution is a classic example of a business externality in that part of the cost of doing business (pollution) is imposed on third parties (the community at large). One of the solutions of this externality problem is to force managers into responding to the community’s stake by controlling pollution. This solution represents a requirement that managers consider the interests of the community and the stockholders in decision-making rather than the stockholders alone.
When might a supplier be a stakeholder? One example of suppliers as stakeholders in decision-making is found in the case of Chrysler. Chrysler had maintained a very close relationship with its suppliers. When Chrysler was on the verge of collapse it’s suppliers responded by cutting their prices and accepting late payments. This response demonstrates how one company will consider the interests of another company in its own decision-making. Another example is the Japanese businessman who as a matter of honor and recognition of a long-standing relationships, sticks with his long-term supplier rather than switching to a cheaper, new supplier of equal quality.
On the stakeholder view there is nothing special about stockholders. In fact, stockholders are not paid profits because they are owners of the firm, rather they are paid profits because their investment is necessary for the continued success of the firm. In other words, stockholders are important, but no more important than the other groups necessary for a corporation’s continued success.
Criticisms of the Stakeholder Theory
The stakeholder theory requires management to consider other interests besides those of stockholders. This consideration may take one of two forms. First, the stakeholder theory may be saying that management must give stockholder interests primary consideration, but must also take into account the interests of other stakeholders in business decision. Second, the stakeholder theory may be saying that management must consider other stakeholders interests as equal to those of stockholders.
Certainly managers can consider the interests of other stakeholders as part of an overall strategic plan to maximize profits. In other words, how labor, the community, or suppliers interests will be impacted by a decision should be considered because it will also impact the stockholders interest. This interpretation of stakeholder theory is flawed in two ways.
1. Though this interpretation considers the interests of other stakeholders, it does so for strategic (rather than ethical) reasons.
2. This interpretation of stakeholder theory fails to differentiate itself from Friedman’s view which could also take into account the interests of others for strategic reasons.
Therefore, if this is how we interpret stakeholder theory, then it fails to be a viable alternative to Friedman’s.
The alternative interpretation is to hold that stakeholder theory requires management to consider the stakeholder interests as equal to the interests of stockholders. This would require a full ethical accounting of the interests of other groups impacted by a business’s decision. However, this view also seems to fail as it results in an ethical paradox. This interpretation would say that it is unethical for management to make decisions that impact stakeholders in order to maximize profit. Yet, in virtue of accepting investments from stockholders, this interpretation is also saying management has an ethical obligation to maximize profit for stockholders. Yet, it cannot be the case that management has both an ethical obligation to maximize stockholder profits and an ethical obligation not to make decisions which maximize stockholder profit. Something has to give; either stakeholders’ interests are not equal, or management has no ethical obligation to maximize stockholder profits.
Splitting the Difference?
One way to uphold the goals of the stakeholder theory, which ethically incorporates the interests of others into decision-making, yet avoid the stakeholder paradox is to consider the corporation as a legal person. Corporations are already considered quasi-persons under the law, but if we extend this legal personhood to an ethical context, we can achieve an acceptable theory of the corporation’s purpose. The purpose of a corporation might still be summed up as maximizing stockholder profit within the rules of the game, but the rules of the game can be the same ethical rules that apply to persons. Just as persons are free to act for their own interests so long as they do so without fraud, deception, or undue harm to the interests of those affected by those actions, managers of corporations are free to act for the interests of stockholders so long as they do so without fraud, deception, or undue harm to the interests of stakeholders. Of course, this modification leaves open the questions of when fraud, deception, or undue harm to stakeholders has occurred, but this will be the focus of latter modules.
This modified view of the corporation is compatible with current law and recent historical trends. For example, corporations in case law have been permitted or required 1) to make a profit, 2) to be accountable to shareholder interests (i.e., the Michigan courts decision to force Ford to pay dividends rather than sacrifice shareholder interests for the public good) and 3) to have management take into account he interests of other stakeholders (i.e., when New Jersey courts upheld corporate donations to private colleges at the expense of shareholders). In addition, shareholder power over corporations has declined since the 1930’s increasingly in favor of stakeholders. Finally, current forces (often citing Friedman) pushing to raise shareholder power are motivated by economic arguments that a) active shareholders increase efficiency and b) shareholder backlash against high executive salaries and other “protect establishment management” policies harm shareholder profits. Where market forces and government regulation have failed to promote efficiency many think increased shareholder power might succeed. Although these current forces offer non-ethical utilitarian reasons for increasing shareholder power, they fail to provide adequate grounds for Friedman’s view.
From this module we can conclude that the purpose of the corporation is to promote the interests of stakeholders. Exactly who is a stakeholder and how we balance the diverse interests of management, stockholders, employees, suppliers and society will be a matter of further examination. We have also seen how corporations are, and can be, viewed as persons in both a legal and ethical context. Understanding corporations as quasi-persons aids our ethical evaluation of corporate actions as such actions are ethically identical to actions we make ourselves.
The video clip below examines the history and consequences of looking at a corporation as a legal person. In addition it looks at the consequences of the corporate person being solely focused on profit maximization for shareholders. Many of the arguments concerning the purpose and nature of corporations discussed in this module are summarized in this clip.
One final case for your consideration involves a comparison between two different corporate cultures. Sam’s Club, which is focused on stockholder profits by keeping costs low, and Costco, which is more broadly focused on all of its stakeholders. The chart below compares the data from the article in our textbook.
Sam’s Club Costco Further Details
Corporate value: Low Prices Taking care of stakeholders Sam’s Club is a division of Wal-Mart and operates in the same corporate culture.
Costco management lists stakeholders in the following order: 1) Members, 2) Employees, 3) Supplies and 4) Stockholders much to the dislike of Wall Street.
Upholds value by: Keeping wages low averaging $10/hr or $21,000/yr
Always pressuring suppliers to reduce costs.
Pays the highest wages for warehouse retail averaging $17/hr or $35,000/yr
Warns suppliers not to give a better price to anyone else.
Wal-Mart does not provide data on its starting or top hourly wages nor does it provide separate data for Sam’s club. The $10/hr rate is the average wage of full time Wal-Mart worker.
Costco wages start at $10 and reach up to $18 not including $2000-$3000 bonuses which are awarded twice each year.
Impact of value: Employee turnover is 44% per year. Being sued for failure to pay overtime wages.
Suppliers goods cheaper in both price and quality.
Suppliers not profiting enough to invest in product innovation.
Suppliers off shoring production to low wage countries.
Positively viewed by Wall Street for keeping focused on growth for higher shareholder returns.
Less than 50% of employees have health insurance coverage.
Poorly viewed by unions and known to fight to block any unionization of employees.
Labor costs 70% of cost of operations, a full 40% higher than Wal-Mart. Employee turnover is 17% overall and drops to 6% after the first year.
Lowered earnings for several quarters before reducing employee health benefits.
Increased worker productivity.
Poorly viewed by Wall Street for doing too much for employees and not enough for stockholders. Also viewed as being to generous to customers by spending shareholder profits to give customers a better shopping experience through more checkout lines.
Sets profit margin cap of 15% for Kirkland brand and 14% for everything else.
CEO salary is only $350,000 plus stock options. 85% of employees have health insurance coverage. Low rate of “shrinkage” (employee theft, shoplifting, and vendor fraud). History of good relations with employee unions.
Wal-Mart’s official stance on unions is that “There has never been a need for a Wal-Mart union due to the familiar, special relationship between Wal-Mart associates and their managers.” The only Wal-Mart store every to officially unionize was abruptly closed prior to negotiations between the company and the new union. When 10 butchers at another store formed a union the company switched to pre-packaged meats and eliminated butchers from all of its stores.
Costco responds to Wall Street’s criticism by taking a long term approach rather than a short term profit now approach. Employees now pay 8% of health costs when industry average is 25%. CEO salary is about 12 times the average workers. In most companies the CEO makes 430 times their average worker.
Financial Results: Sam’s Club has 110,000 workers in 551 warehouse stores generating $37 billion in sales during 2005. This means a profit generated of around $11,000 per employee. Sam’s employees sold $525 in sales per square foot. Costco has 67,000 workers in 338 warehouse stores generating $43 billion in sales during 2005. This means a profit generated of around $21,000 per employee. Costco employees sold $886 in sales per square foot. This comparison is directly between Sam’s Club and Costo where previous data compared Wal-Mart to Costco.
Sam’s Club has higher hiring and training costs due to turnover as well as higher shrinkage costs and lower worker productivity than Costco.
The author concludes with a comparison of the high wage vs. low wage model by pointing out that the increased loyalty and productivity of the high wage model more than pays for itself. Sometimes you get what you pay for. Beyond the direct business comparison in which a high wage model can (counter intuitively to many on Wall Street) beat the low wage model, there are also social costs and benefits to be considered. What are the implications of lower wages, less innovation, less health care benefits, fewer retirement benefits, more off shoring, cheaper goods, and less product innovation? More poverty is linked to more crime and poor workers require more government health and retirement benefits which has been shown to raise taxes on everyone else. In addition, as more businesses adopt a low wage model there has to be a reduction in consumer spending which will slow economic growth. Factoring the social and economic costs of the low wage model and benefits of the high wage model may demonstrate that more than just business benefits from a shift to the high wage model.
Some questions to consider:
1. What would Friedman say about this comparison?
2. What would a proponent of the stakeholder view say about this comparison?
