Monday, July 14, 2008

Stakeholder Theory Mistakes

Those who lobby for the stakeholder theory of the corporation believe that it is possible for a corporation to ignore its unhappy customers, compromise its accounting standards, produce faulty products, pollute its environment, ignore its competition, and still create value for its shareholders.

They claim this rather remarkable feat is possible under the shareholder theory of the corporation, which elevates shareholder value over the values of all other groups (i.e., "stakeholders") affected by the corporation.

In their attack on the primacy of shareholders, the advocates of the stakeholder theory make three serious errors, mistakes that doom their entire argument. These errors concern the difference between short term and long term shareholder value; the difference between monopolies and competitive corporations; and the reliability of prices.

Is it truly possible to create shareholder value by ignoring unhappy customers, etc? Yes, such an outcome may be possible, but only for a little while. It is impossible to create long term shareholder value with such behaviors, because customers, accountants, employees, communities, and investors all have other choices.

Such an outcome is far more likely -- almost guaranteed -- in situations where people are forcibly deprived of other choices. But we don't call those situations markets. We call them monopolies, and monopolies exist only with the collusion of the state. Only the state has the power to limit competition, set prices, and compel non-shareholders to create value for shareholders.

But such value is not earned; it is extracted from one group for the benefit of another. Governments that create monopolies may create the appearance of a market economy, but in reality those "markets" are centrally planned.

Examine the heart of a planned economy, and you may find the form and substance of a corporation, but you will not find competition. This is the critical distinction that stakeholder theory glosses over. All corporations are not created equal. The more a corporation is protected from competition, the more likely it is to be a mechanism for involuntary wealth transfer, not voluntary wealth creation.

Prices matter as much as competition. Ultimately, shareholder value is just another price. Like all prices, it is sensitive to dynamically changing factors in a complex web of action. Just as the price of any good captures the varied interests of producers, manufacturers, distributors, wholesalers, retailers, and customers, long term shareholder value captures the varied interests of customers, employees, suppliers, communities, shareholders, and even competitors, and it does this better than any other measure of corporate responsibility.

Denying that the purpose of a corporation is to increase long term shareholder value is nothing less than an attack on the reliability of the price system itself. Stakeholder theory elevates other forms of value over the value contained in prices, especially that price we call shareholder value. It is a theory of business that has more in common with price control than with profit and loss.

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