Stakeholder Theory and the Challenge of Welfare Economics
In a new paper posted on SSRN, I argue that stakeholder theory will not become fully intellectually respectable until it adopts the concepts and methods of welfare economics.
As everyone involved in corporate governance knows, stakeholder theory holds that directors should manage the corporation for the benefit of all its stakeholders, including not only its shareholders but also its employees, customers, creditors, and suppliers, as well as any other individuals affected by the corporation’s operations. In an age of climate change and concern about greenhouse gas emissions, the stakeholders of a corporation can reasonably be understood to include everyone now living or to be born in the future. The imperative to maximize stakeholder welfare can thus become an imperative to maximize social welfare generally.
All serious observers realize, however, that, even when the class of stakeholders is drawn narrowly, it virtually never happens that what is good for one stakeholder is good for all stakeholders. Rather, in the typical case, what is good for some stakeholders is bad for others, and what some stakeholders prefer others disprefer. It is essential to stakeholder theory, therefore, that directors balance the competing interests or aggregate the conflicting preferences of stakeholders in order to choose the course of action that is—in some sense—best for all stakeholders collectively.
This raises a critically important conceptual question that stakeholder theory must be able to answer: what does it mean to say that a course of action that affects some individuals positively and others negatively is “best for everyone” or “best collectively”? Until such expressions are given a clear meaning, stakeholder theory itself has no clear meaning.
When we ask what is best for a single individual, one natural answer is that what is best for an individual is what the individual himself would prefer. This privileging of the individual’s own preferences is known as welfarism, and it may be based on philosophical views about personal autonomy or merely on the pragmatic observation that, although anyone can be wrong about what is best for himself, an individual’s own views are more likely to be right than anyone else’s. The alternative to welfarism is a robust normative theory that tells us what is best for an individual regardless of what the individual himself may want or believe; this is the paternalistic attitude we generally adopt towards children or the mentally incompetent. The assumption in my new article is that stakeholder theory is welfarist, that is, in determining what is best for everyone collectively, it assumes that, for each individual, what is best for that individual is whatever that individual himself would prefer.
But once we assume that the stakeholder theory is welfarist, the problem of making a business decision under stakeholder theory becomes a paradigm problem of welfare economics. In contradistinction to positive economics, which seeks to predict human behavior, welfare economics investigates how to obtain normative orderings of alternative possible states of the world based on information about the preferences of individuals in each possible state. That is, using explicitly stated normative assumptions and the techniques of microeconomics, welfare economics gives precise meaning to the idea that, when there are many alternative courses of action that affect different individuals differently, one of these alternatives is “best” for all the individuals collectively. Of course, this is exactly what stakeholder theory needs: some way of explaining what it means to say that a course of action that affects different stakeholders differently is “best” for all stakeholders collectively.
Welfare economics, which goes back to Marshall and Pareto, is a highly developed branch of economic theory, with both Arrow and Sen having won Nobel Prizes for their contributions to the field. It provides sophisticated concepts and methods that a board of directors could adopt in practice in making business decisions in accordance with the stakeholder theory of corporate governance. Given that there seems to be no other way of providing a coherent formulation of the stakeholder theory, adopting the concepts and methods of welfare economics to explicate the theory would seem to be the natural thing for advocates of stakeholder theory to do.
Thus far, however, this has not happened. Stakeholder theorists commonly recommend particular corporate policies (e.g., regarding climate change or economic inequality) as being consistent with or even required by stakeholder theory, but no such theorist has even begun to adopt the concepts and methods of welfare economics to give a clear meaning to the imperative that directors should maximize stakeholder welfare, much less to implement stakeholder theory in a disciplined and rigorous way in connection with particular business decisions. This failure raises profound issues for stakeholder theory.
If stakeholder theory is even to state coherently the goal that it proposes that corporate directors pursue (i.e., doing what is best for all stakeholders collectively or maximizing stakeholder welfare), and if stakeholder theory adopts the welfarist view that what is best for an individual is determined by his own preferences, then it certainly seems that stakeholder theory must rely on the tools at hand supplied by welfare economics, such as ordinal and cardinal preferences, Arrow’s Impossibility Theorem, cardinal utility functions, Sen’s extension of Arrow’s framework, the money metric and equivalent income functions, compensating variations and equivalent variations, and cost-benefit analysis. It is also possible, though just barely, that stakeholder theorists could explain why these seemingly obviously relevant concepts are not relevant to stakeholder theory after all. What stakeholder theorists cannot plausibly do, however, is present a theory employing unanalyzed concepts of welfare maximization or doing what is best for a group of individuals collectively while simply ignoring well-known results in a major branch of economic theory that has had considerable success in analyzing such concepts.
An analogy will help. Under the traditional shareholder theory of corporate governance, directors have a fiduciary duty to maximize the value of the corporation for the benefit of its shareholders. Maximizing the value of the corporation, however, involves investing in projects today in order to receive returns tomorrow—i.e., trading off cashflows today for cashflows in the future. Long ago, managers made such decisions using intuition and commonsense. For many decades now, however, managers have routinely used the concepts and methods of financial economics, such as discounted cashflow analysis, beta as a measure of risk, and the Capital Asset Pricing Model. In any significant capital budgeting decision, and certainly when buying or selling a whole company, it is practically inconceivable that managers would not use such tools. Indeed, even to assign a clear meaning to the claim that a business decision increases shareholder value requires the tools of financial economics: the claim is nowadays understood to mean that the expected future cashflows from the decision, discounted to present value at the appropriate discount rate as determined by the Capital Asset Pricing Model (or some more sophisticated model in financial economics), exceeds the costs of the decision—i.e., that the decision has positive net present value.
Directors implementing the stakeholder theory of corporate governance are thus in a position analogous to that of directors implementing the shareholder theory. Both theories can be stated at the level of intuition and commonsense, but, in both cases, the goals that the theories hold that directors ought to pursue—doing what is best (or maximizing welfare) for stakeholders under the stakeholder theory, maximizing value for shareholders under the shareholder theory—lack clear meanings and can be formulated coherently, and pursued rationally, only with the aid of economic theory. Generations of economists—financial economists with respect to the problem of value maximization, welfare economists with respect to the problem of welfare maximization—have analyzed the issues involved, made significant progress in understanding them, and have developed sophisticated concepts and methods to deal with the relevant problems. On the shareholder side, directors of public companies, which overwhelmingly operate under the shareholder theory (Delaware law requires it), have for decades routinely employed the concepts and methods of financial economics in making business decisions, at least when the decisions involved were significant enough to justify a rigorous analysis.
On the stakeholder side, however, things could not be more different. Advocates of stakeholder theory have utterly failed even to begin the work of integrating the concepts and methods of welfare economics into stakeholder theory. They constantly speak in general and undefined terms of directors managing the corporation for the benefit of all stakeholders, of their balancing the interests of different corporate constituencies, or of their maximizing stakeholder welfare as if these expressions had clear meanings, when, in fact, well-known results in welfare economics show indisputably that they do not.
Simply put, if stakeholder theory is to become a fully intellectually respectable theory of corporate governance, it needs to rise to the challenge of welfare economics. Stakeholder theorists must come to terms with well-known results in that discipline and explain how its concepts and methods can be adapted by corporate directors to make business decisions. This will likely be a very difficult undertaking. While it is no part of the purpose of my article to suggest that stakeholder theorists could never successfully formulate their theory in accordance with welfare economics, I do explain some of the more difficult issues that stakeholder theorists will have to face, including problems related the interpretation of cardinal utility functions in Sen’s extension of Arrow’s framework, problems related to choosing a social welfare function (including some of the value judgments that go into choosing such a function), Singer’s self-despoliation argument, and Parfit’s so-called repugnant conclusion in cases where populations vary over time.
In advocating for their theory of corporate governance, often in urgent terms, stakeholder advocates give the impression that corporate directors could immediately begin implementing that theory. By emphasizing the difficulty and complexity of the challenge that welfare economics poses for stakeholder theory, I argue that this impression is flatly false. Rather, in accordance with well-known results in welfare economics, adapting the tools of welfare economics to the kinds of problems that directors typically face would necessarily involve making not only some difficult and controversial value judgments, but also some utterly heroic assumptions concerning the preferences of stakeholders and the ability of directors to discover them.
In order to become fully intellectually respectable, stakeholder theory needs to adopt the concepts and methods of welfare economics. Whether it can do so is unclear. In order to become practically useful, however, stakeholder theory must also adopt the concepts and methods of welfare economics, but must also do so in a manner that corporate directors could actually apply in practice to make business decisions. Whether this can be done is even more unclear. Until both of these tasks are accomplished, however, stakeholder theory cannot be a serious competitor to the traditional view that directors should manage the corporation for the benefit of its shareholders.
