The shareholder wealth maximization norm and industrial organization.

AuthorRoe, Mark J.
PositionSymposium on Norms and Corporate Law

Industrial organization affects the relative effectiveness of the shareholder wealth maximization norm in maximizing total social wealth. In nations where product markets are not strongly competitive, a strong shareholder primacy norm fits less comfortably with national wealth maximization than elsewhere because, where competition is weak, shareholder primacy induces managers to cut production and raise price more than they otherwise would. Where competition is fierce, managers do not have that option. There is a rough congruence between this inequality of fit and the varying strengths of shareholder primacy norms around the world. In continental Europe, for example, shareholder primacy norms have been weaker than in the United States. Because Europe's fragmented national product markets were historically less competitive than those in the United States, their greater skepticism of the norm's value came closer to fitting the structure of their product markets than did any similar skepticism here. As Europe's markets integrate, making its product markets more competitive, pressure has arisen to strengthen shareholder norms and institutions.

INTRODUCTION

I make a single, simple point in this Article: the relative value of shareholder wealth maximization for a nation is partly a function of that nation's industrial organization. When much of a nation's industry is monopolistically organized, maximizing shareholder wealth would maximize the monopolist's profits, induce firms to produce fewer goods than society could potentially produce, and motivate firms to raise price to consumers beyond that which is necessary to produce the goods.

  1. SCOPE

    A few words on scope: I do not specify here the source of shareholder primacy norms. These norms could come from culture, from institutions, or from rules. Nor do I focus on what does the work: the norm or the underlying institutions and rules. I instead focus on the fit between the norm (or its underlying institutions and rules) and industrial organization.

    Disentangling norms from practices is not easy. It would be odd for a nation to have norms sharply differing from practices, institutions, and laws. Because norms are usually congruent with practices, institutions, and laws, knowing which element is critical is hard.

    Another limit to the paper: I have nothing here to say on the absolute value of a shareholder primacy norm. It may be so critical for organizing large private firms that even where it fits badly with industrial organization, it is nevertheless worth pursuing. Or it may so diminish total social wealth (a minority view today) that it is not worth pursuing single-mindedly anywhere. Or it may be so brutal if pursued single-mindedly that no organization and no society can absorb it in its pure form. Perhaps the norm must be softened to survive.(1) I instead make the point that its relative value depends on industrial organization and that there has been a rough congruence around the world with this relative value.

  2. THE UTILITARIAN BASIS FOR SHAREHOLDER WEALTH MAXIMIZATION

    The prevailing academic and business view in the United States is that shareholder wealth maximization fits with a utilitarian, greatest-good-for-the-greatest-number philosophy. But would a nation with concentrated industry be as well served by strong shareholder wealth maximization institutions?

    Shareholder wealth maximization is usually accepted as the appropriate goal in American business circles.(2) The norm makes some uneasy, though: after all, why should shareholders, who usually are favored members of their society, prevail over, say, current employees, who usually are less favored?

    The utilitarian justification is that this preference is the price paid for strong capital markets, and allocative efficiency and that these benefits are so powerful that they overwhelm the normative benefit of any distributional favoring of current employees over current shareholders. In the long run, the argument goes, employees and other stakeholders are overall better off with fluid and efficient capital markets, managers need a simple metric to follow, and both wealth and, in the end, fairness are maximized by shareholders being the corporation's residual beneficiary, with the other claimants getting what they want via contract with the corporation. Current employees might be made worse off in some industries, but employees overall will have more opportunities, higher salaries, and better working conditions. Furthermore, a stakeholder measure of managerial accountability could leave managers so much discretion that managers could easily pursue their own agenda, one that might maximize neither shareholder, employee, consumer, nor national wealth, but only their own.

    But that sketch is weaker in a nation with mostly concentrated industry and weak product market competition. Enhancing shareholder wealth maximization in that kind of a national economy may, even if the baseline utilitarian argument is correct, reduce national well-being, as we next see.

  3. SHAREHOLDER WEALTH MAXIMIZATION AND MONOPOLY RENTS

    1. Shareholder Primacy Could Diminish GNP if Industry Is Concentrated

      Consider the monopolist's discretion. In Graph 1, a stripped-down version of the basic supply-demand setting for a monopoly, the monopolist can restrict production, raise price, and maximize its monopoly profit by finding the price-quantity combination that makes the "rectangle" (and, hence, its profits) as big as possible.

      [GRAPH OMITTED]

      The monopolist could, if it wanted to, produce the amount that a competitive industry would produce. If it did so, it would not be maximizing its own wealth, because it would be leaving that "rectangle" of profits on the table. The consumers' triangle would be maximized. The monopolist would also, incidentally, usually employ more people as production would rise compared to the constricted production when monopoly profits are maximized. It would maximize the nation's wealth, not its own.

      A strong shareholder wealth maximization norm will induce the monopolist's managers to lower production, to raise prices, and to lower employment. Weaker shareholder primacy norms could (plausibly but not necessarily) increase national wealth in a nation with highly concentrated industry.

      Weaker shareholder primacy institutions could induce the firm to move down the demand curve, producing more and lowering price. This point is consistent with a standard view on agency costs: If unconstrained managers usually prefer to build larger firms, if they usually prefer to build new factories, and if they usually prefer sales to profits--all of which are typically the core managerial agency costs to shareholders--then they are more likely in a concentrated industry with weak shareholder wealth maximization to travel down the demand curve by first producing more and then concluding that they cannot aggressively raise price. The weakly controlled managers could produce more national wealth than the tightly controlled ones.(3)

      To be sure, this increase in social wealth, while a plausible effect of weakened shareholder primacy in a monopoly, is not its only possible effect. Most obviously, loosening constraints on managers may just mean that the managers take more for themselves rather than increase production. One could, however, imagine a society with weak shareholder primacy norms but strong antitheft institutions: Managers are precluded from taking for themselves but are not instructed as to what they can do with the potential pot of monopoly profits. When incentives and markets are weak, they have discretion. Even here there is ambiguity. In the United States, "managers taking more for themselves" has led to higher salaries, more perks, and bigger but less profitable empires, all of which have generally negative social effects when product markets are competitive. But when product markets are uncompetitive, the firm that expands to produce more could be socially positive, assuming the empire is not an unproductive one.

      Conversely, managers on a short leash might stay at the same point on the demand curve, but economize more on resources if they must maximize shareholder wealth. Economizing inputs tends to offset the maximizers' reducing output. In an economy with widespread monopoly, some firms encouraged to maximize shareholder wealth would primarily economize, while others would slash production and reduce allocative efficiency. One cannot predict which effect would dominate.

      More subtly, ex ante incentives would diminish if, after a monopoly was acquired, institutions, rules, and norms weakened the shareholders' profits. Which effects--the negatives of incentive effects and managerial grabs of the rents or the positive of a better ex post allocative efficiency--would dominate is a priori uncertain. Hence, nations with concentrated industries and many monopolies and oligopolies have reason to be less enthusiastic about, and conceivably even to denigrate, shareholder primacy (depending on which effects--incentives and reducing waste or allocative efficiency--they predict would dominate).(4) Historically, the ambiguous balance was strongly in play in continental Europe where monopolies were more widespread, but weakly in play in the United States where they were less widespread.(5)

    2. The Ambiguity of Pro-employment Corporate Governance Policies

      Employees of monopoly firms can, and do, ally with capital to split the rents, to facilitate constricting production and raising price, and to seek barriers to competitive entry. That is, employees whose jobs are already set and secure often represent themselves, not the whole labor pool of all potential employees; some of those in...

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