At ASA, listening to some talk that referenced the age-old (or, at least, 100+ year old) debate on ownership and control, I hit on a silly thought experiment that might help make clear the argument that it’s actually quite a big problem that owners no longer have much of a say in management*, and why Milton Friedman’s assertion that “The Social Responsibility of Business is to Increase its Profits” doesn’t make sense.

First, the set-up. Friedman, along with gobs of other smart people, believe that managers of businesses are agents of the owners (shareholders) of the business, entrusted with the legal obligation to maximize profits for the owners***. Legally, managers have a “fiduciary” obligation to make money, and Friedman and co think that’s just as it should be. When managers start mucking about trying to be socially responsible, that’s when everything goes wrong. Why? Because then the manager is replacing the owner’s preferences with his (or, more recently, her) own preferences. Here’s Friedman:

In a free-enterprise, private-property sys­tem, a corporate executive is an employee of the owners of the business. He has direct re­sponsibility to his employers. That responsi­bility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while con­forming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.

If you believe that owners simply want to “make as much money as possible”, Friedman’s argument makes a fair amount of sense (and I recommend reading the rest of the essay, as Friedman connects social responsibility to socialism in only a few short paragraphs). Do we any longer believe that owners simply want to make as much money as they can within the rules? Why would we believe that? As I’ll discuss more in a moment, a larger share of ownership is held by institutional investors, especially pension funds. There’s also been a tremendous growth in “socially responsible investing” (which Daniel Beunza has done some recent work on). More basically, I don’t think many sociologists would agree that people are motivated by a narrow profit-motive. Most people are other-regarding to various degrees, and no one wants money simply to have money – or almost no one. Rather, we want money because we are other-regarding, and want things like status, influence, or health that we can purchase with money (or that having money will bring us).

So, if we abandon the simplistic idea that owners want solely money, I think Friedman’s contention that corporate executives know the desires of the owners becomes unrealistic. Companies have millions of shareholders, dispersed throughout the country and world. To borrow (dangerously) from the Austrians for a moment, why would we think that corporate executives are better capable of accurately understanding the desires of a diffuse set of actors than a government? In other words, why do we think corporate executives can solve the knowledge problem accurately to get an appropriate preference function against which to evaluate their own behavior? If we don’t think they can, then there is a role for investor activism, *and* for corporate social responsibility (in some sense, at least) urged by those same investors. I.e. Executives get it wrong – sometimes they think they should be doing X (making more money but as some social cost), but really the owners of the corporation would prefer Y (less money for the firm, but a better societal outcome). Owners, especially as represented by institutional investors, might be in a position to know better what they want for themselves (or through another set of agents, the investment managers).

Now we get to the thought experiment(s) part. The California Public Employees’ Retirement System runs a truly massive pension fund with something like $200 billion under management. Imagine CALPERS (or some other large, public fund) owns 10% of a big company. Imagine that company has an entirely legal way to make an extra million dollars, but ten random Californians will die because of this action. The corporation will have no legal responsibility for the death – it’s just a negative externality of a completely legal transaction****. Pretend it’s a bit more indirect, like a reduction in the reliability of a service that indirectly (but predictably) leads to a few more people getting injured, or receiving care in a less timely way, etc. Would CALPERS want the corporation to take the action? My guess is that they would not!

So, here we have a case where the corporate executive has the choice between making more profits – its responsibility, according to Friedman and to a very narrow and unenforceable interpretation of the law – and being socially responsible. And if owners actually had any good mechanism for exercising their ownership over resources – as they did back before the separation of ownership and control in the late 19th and early 20th century – you better believe they would do so. But the institutions we have in place allow for only a very few sorts of indirect control by minority shareholders – even very large ones. (Melissa Forbes’ dissertation is on exactly this topic, with regards to climate change and Ford.)

Anyway, what I’m trying to establish with this experiment is a circumstance under which an executive must choose between doing what the owners want and making money. If we admit the possibility of such a circumstance, and the possibility that executives might have trouble knowing what the owners want, then Fredman’s dictum becomes worthless. Let me end with a long quote from Friemdan again, on the differences between politics and markets:

The political principle that underlies the market mechanism is unanimity. In an ideal free market resting on private property, no individual can coerce any other, all coopera­tion is voluntary, all parties to such coopera­tion benefit or they need not participate. There are no values, no “social” responsibilities in any sense other than the shared values and responsibilities of individuals. Society is a collection of individuals and of the various groups they voluntarily form.

The political principle that underlies the political mechanism is conformity. The indi­vidual must serve a more general social inter­est–whether that be determined by a church or a dictator or a majority. The individual may have a vote and say in what is to be done, but if he is overruled, he must conform. It is appropriate for some to require others to contribute to a general social purpose whether they wish to or not.

Unfortunately, unanimity is not always feasi­ble. There are some respects in which conformity appears unavoidable, so I do not see how one can avoid the use of the political mecha­nism altogether.

But the doctrine of “social responsibility” taken seriously would extend the scope of the political mechanism to every human activity.

Here we see a clear expression of what Polanyi called the “stark utopia” of free markets – a perfect world in which all cooperation is voluntary, and power does not exist. Friedman believes such a principle really underlies actually existing markets, and that the more we try to bring social concerns into markets, the less markets fulfill their ideal functions. But if we believe that free markets are in fact impossible, that markets are always already politically, culturally, technologically embedded/enmeshed/etc. in other systems, then we must admit that the political mechanism has already been extended to every human activity – or at least to the economic realm. Berle and Means criticized contemporary economic theory (in the 1930s) for pretending that our economy was still made of the same stuff as Adam Smith’s – small businesses, independent farmers, and the like. They argued that we live in an era where large corporations look and feel more like governments than like the proprietor-run enterprises of the past. That trend, debated in 1930, has only been solidified over the past 80 years. We live in a world of large organizations owned by conglomerates of smaller actors. Let’s not try to justify those big fish ignoring the whims of the smaller ones by assuming away all the complexities of their preferences and summing it up as “increasing profits”. We know too much to believe that anymore.

* See also Berle and Means 1932, Useem 1996, Mizruchi 2004, Mizruchi and Hirschman 2010.**
** See how I slipped that last one in there? Look Ma, I’m published!
*** I recommend Lynn Stout’s The Mythical Benefits of Shareholder Control for more on this topic.
**** Hey, it’s my thought experiment, alright? I know there are issues here, but let’s pretend for the moment. We can debate how good a job the law does of internalizing all kinds of costs (like those of pollution), but you’d be hard pressed to argue that it gets everything exactly right.