Shareholder and Stakeholder Paradigms

The story about the bookstore highlights the two main theories on why firms exist: the shareholder and stakeholder paradigms. The term shareholder refers to the financial owner(s), or stockholders, of the organization. By contrast, the term stakeholder is used to refer to any person or institution that has interest in the well-being of an organization and is impacted by the organization's actions. For example, in addition to the owners, stakeholders include the community and government where the organization resides, as well as the organization's workers, suppliers, and customers (see Figure 1-1).

Figure 1-1: Stakeholders

Let's take a deeper look into the shareholder and stakeholder paradigms.

The Shareholder Paradigm

If you ever take a corporate finance class, you will probably memorize the following: "The goal of the firm is to maximize shareholder (or owner) wealth." Where did this idea come from? Answer: In 1931, in a Harvard Law Review article, A. A. Berle suggested that corporations should create benefits for shareholders. In other words, managers are the "guardians" or "trustees" of the shareholders. Under Berle's perspective, managers do not need to consider the interest of all stakeholders, just the shareholder.

More recently, Nobel laureate Milton Friedman, one of the most influential economists of the 20th century, reiterated Berle's perspective that organizations have the sole responsibility to provide financial gain for the organization's shareholders, noting, "The social responsibility of business is to increase its (the organization's) profits." Under Friedman's assumption, the executives of an organization are the employees of the shareholders. As such, employees have the responsibility to make as much money as possible. An underlying assumption of Friedman's argument is that while businesses should maximize their profits, they must still obey the legal rules and ethical customs of society.

Today, the shareholder focus is widely held and almost always serves as the framing for financial management. Under the shareholder theory, firms exist and managers manage to maximize the wealth of the firm owners. If the firm is publicly held or has shareholders, then this equates to maximizing shareholder wealth. If the firm does not have shares, then it is simply to maximize owner wealth.

The Stakeholder Paradigm

Not surprisingly, not everyone agrees with Berle and Friedman. In fact, only one year after Berle proposed the shareholder paradigm, E. Merrick Dodd challenged this shareholder-centric perspective, arguing that corporations should also consider the interests of the organization's workers, consumers, suppliers, and society as a whole in the decision-making process. Dodd believed that organizations have a responsibility to all stakeholders—not just shareholders. A number of prominent business leaders supported the idea that companies must take a more holistic approach. For example, Henry Ford, the famous American industrialist once stated, "For a long time people believed that the only purpose of industry was to make a profit. They are wrong. Its purpose is to serve the general welfare."

Since the 1990s, many thought leaders have turned to the stakeholder paradigm to argue for a more balanced approach to corporate goal setting and decision-making. Specifically, they argue that although limited by rules and regulations, a free market system often pressures individuals to engage in greed, excess, and abuse. Adopting a stakeholder perspective means that managers should not simply focus on economic performance. Rather, managers should also consider their organizations' social and environmental performance. Simply put, a stakeholder perspective requires companies to act as good corporate citizens—the essence of corporate social responsibility (CSR). Importantly, since diverse stakeholders often have conflicting goals, managers must often evaluate tradeoffs across stakeholders to decide which course of action to take. Thus, pursuing a stakeholder approach is seldom easy.

Now, let's return to our bookstore example. Suppose the bookstore used a balanced approach to add the most value possible to all of the stakeholders—the owners of the firm for sure, but also the students, the professor, the book publisher, the book authors, and everyone else impacted by the sale/purchase of the text. Which paradigm would the book store be using? You got it—the stakeholder theory.

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