If a company donates $1 to charity, that’s no more effective than if it paid out that $1 as a dividend to shareholders and they gave it to charity. The only socially responsible action that Friedman considers is charitable donations. But, critically, he assumed that companies have no comparative advantage in achieving these social goals. They argue that the owner’s welfare contains ‘not only the benefits he derives from pecuniary returns but also the utility generated by various aspects of his entrepreneurial activities such as … the kind and amount of charitable contributions, personal relations (‘love,’ ‘respect,’ etc.) with employees’.įriedman, too, recognized that shareholders may have non-financial goals. They start with a manager who owns ‘his’ (assumed male by JM) entire firm, and so there are no agency costs. But JM go beyond Friedman by making a critical distinction between shareholder welfare and shareholder value. In my article on Friedman, I highlighted how his advocated goal of shareholder value is critically different from short-term profits- shareholder value is the present value of all future cash flows, including those in the very long term. It is to maximize shareholder ‘welfare’ (which they sometimes refer to as ‘utility’), not short-term profits. While their focus was on ownership structure, a key starting point was what they viewed as the goal of the firm. What Did Jensen And Meckling Actually Say? Advocates of stakeholder capitalism, such as me, should use it to guide us rather than ridiculing it. But the JM article is far more nuanced than commonly portrayed. There’s a strong incentive to caricature Friedman and JM, as it’s easy to push your view of how capitalism should be run if the status quo appears stuck in the dark ages. Interestingly, Wikipedia attributes the paper to ‘Meckling and Jensen’, raising the possibility that the commentaries are based on reading a Wikipedia entry, rather than the article itself. And the same is true for JM-some critiques refer to ‘Meckling and Jensen’ when the start of the article clearly states that it is by ‘Jensen and Meckling’, both of Rochester. In an earlier ProMarket article, I explained that many criticisms of Friedman are based on serious misunderstandings about what he actually wrote, casting doubt on whether their authors actually read beyond the title. This might involve rewriting the law to change directors’ fiduciary duties away from shareholders, dual-class share structures that restrict the voting rights of outside investors, or stakeholder representatives (such as employees) on the board. A Forbes article argues that ‘Meckling and Jensen thus took the Adam Smith’s metaphor of an “invisible hand” and proposed a license for enterprises to pursue unbridled self-interest across an entire society’.Īccording to these critics, the solution is to renounce JM and radically reform capitalism so that companies are insulated from shareholder interests. Former advertising executive Simon Sinek alleges that ‘William Meckling, of the University of Rochester, and Michael Jensen, of the Harvard Business School’ came up with the ‘answer everyone was looking for’, ‘a simple metric for measuring corporate performance’-the short-term stock price. The same article claims that firms should ‘use large debts (especially through LBOs) as a further external discipline’. The Economist argues that JM advocate ‘tying their incomes to profits’. But JM takes second place for apparently claiming that the structure of companies should ensure that managers indeed pursue this goal. Their primary target is Milton Friedman’s op-ed ‘ The Social Responsibility of Business is to Increase Its Profits’, which allegedly argues that the goal of companies should be to the exclusive maximization of short-term earnings. Yet despite their article being an academic classic, Jensen and Meckling (‘JM’) is the object of scorn and ridicule by many practitioners today, especially advocates of stakeholder capitalism. It’s been cited nearly 100,000 times and inspired entire streams of research. Their paper, titled ‘ Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, highlighted the agency costs-losses to welfare-that arise when managers don’t act in shareholders’ interests. In 1976, economists Michael Jensen and William Meckling published what turned out to be the most cited academic business article of all time.
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