Shareholder Wealth Maximization -

Theory & Critique

1. Title
Hi everyone!

welcome to the first presentation of this course. My topic is "Shareholder Value

Maximization". We might all have heard about this maxim before, but I would like to
discuss it in more details, its theoretical background, the critique, and the solutions.

2. Agenda
My goals are firstly to give you some comprehensive information about the topic, from
which we could raise more questions and hopefully have a nice discussion of it. I would
deal mainly with two core questions:

Why do firms exist?

What should they do?

In this order, we will revisit the theory of the firm of Ronald Coase, review the theoretical
background of "Shareholder Value Maximization", and examine the critique of Jones &
Felps as well as their alternative theory for the normative question of what a firm should
do.

The presentation would last around 12 minutes, then there will be a questions and
discussion session to answer your questions. So, let's begin.

3. Why do firms exist?

In order to discuss the normativity of what a firm should do, firstly we have to answer the
question "why does it exist?".

Just simply imaging if there were no firm at all, then all the steps of a production process
would be carried out independently by many individuals.

So what would happen if you want to buy the final product of such a process? You would
have to go through it from the beginning until the end all by yourself, because there
wasn't such an intermediary that connects all of those people together. The costs of going
through this process by yourself are called "transaction costs".
4. The Nature of The Firm - Coase (1937)
In 1937, Ronald Coase published a paper about this. He concludes that firms exist to
minimize such costs. By coming together and forming a firm, people could save time,
money, and e ort to produce the goods they need, the Nature of The Firm is e ciency
orientation. However, the question is still how much e cient should the firm be?

5. A hypothetical Problem
There are di erent ways to answer this question, but I'm personally interested in Tobin's
Separation Theorem in Finance because it is quite intuitive. Let's consider a simple
hypothetical problem:

Suppose there are two people, together, they could produce two goods A and B from
given-once-in-a-lifetime resources. Each of them has a di erent preference about
how much of each good A and B should be produced. The Question is: "Which
production bundle should they produce to satisfy both of them?"
This problem is illustrated on the graph. The concave curve is the Production-
Possibility Frontier (PPF). It is the collection of all possible Production Bundles
when the resources are used up. The preferences of the two people 1 and 2 are
respectively presented by the two utility curves U1 and U2. Here we can see a conflict
of interest between them as the individual 1 prefers to consuming more of the good
A at the Bundle C1 while the individual 2 wants to consume more of the good B at
the Bundle C2.

6. A Theoretical Background for SWM 1

When markets do not exist: Each individual has to make a sacrifice by lowering her
expected utility and choose the Bundle Capital-M to produce. As you can see from the
Figure, both end up on a lower utility curve with the Bundle Capital-M, otherwise the
conflict could never be resolved.

7. A Theoretical background for SWM 2

But when markets exist (presented by the Red Line on the Graph), at the same Production
Bundle Capital-M, now each individual has the choice of trading one good for another to
reach a better consumption bundle. So there is no more a conflict of interest. They no
longer need to care about the preference of another and the only decision to make would
be which production bundle Capital-M to produce.

By optimum, this bundle is the tangent point of the market line and the PPF, because this
point would maximize the value of the production bundle and o ers the highest freedom
of choice when the two people use the market to reach their optimal bundles.

So the final solution to the problem is that the two people would exhaust the given
resources to produce the bundle that has the highest market value, then use the markets
to reach their preferred consumption bundles.
In the context of modern firms, the manager also faces the same problem of conflict
interests. According to this theoretical solution, the agent doesn't need to care about the
preference of each shareholder, she just needs to maximize the firm profit and markets
would allow the shareholders to fulfill their preferences.

On this theoretical background, the maxim Shareholder Value Maximization has been
born, accepted, and followed by many economists as well as financial managers.

8. A utilitarian Framework
This analysis has been extended in a utilitarian framework and well supported by many
famous economists according to Jones & Felps. The utilitarian logic is that:

If markets are competitive, firms would be e cient because they have to use
resources as productively as possible to maximize shareholder value (or profit).
If all firms are e cient, the markets would be e cient and bring about the highest
level of aggregate economic wealth, because the resources are used the most
productively.
the highest level of economic wealth leads to the greatest social welfare.

As you can see from such a logic, there are links between competitive markets, firm
e ciency, economic welfare, and human happiness, so if one of the links is weak, the
logic doesn't make sense, and that's where Jones & Felps criticize its validity.

9. The Critique
The critique of Jones & Felps has been summarized in the table. They argue that:

Firstly, competitive markets usually do not exist. As we can see nowadays, the
markets tend to be monopolistically competitive. Each firm has some technologies
that help di erentiate its product with those of the others, so each firm has some
level of market power.
The second argument is that SWM doesn't relate to economic e ciency. The
structure of the firm nowadays is so complex, so a blind pursuit of SWM would lead
to a conflict in interests between shareholders and stakeholders, because profit is
not the only factor that a ects the performance of a firm. Trust and social
preferences also have their influences. So there are often better ways to improve
firm profitability.
Moreover, they also argue that firm e ciency doesn't necessarily lead to higher
economic welfare. This might be the case because of the externalities of the
production process. Bad externalities impose many extra costs on society and, in
some cases, these costs are higher than the incremental economic welfare.
Finally, higher economic welfare might not lead to greater happiness, because a
property of material consumption is the diminishing return. Jones & Felps refer to
many researches that indicate almost no correlation between economic welfare and
happiness when living standards are already high.
From those arguments, Jones & Felps conclude that the theoretical background for the
belief that SWM would improve social welfare is of dubious validity because the
arguments are weak at every link. However, this conclusion would not be so convincing if
they didn't have any backup theory to correct the failures of the original one. Indeed, they
have one.

10. Solutions to those shortcomings

Before going to the details of their suggested solution, they have also discussed another
attempt to overcome the limits of the classical theory. That is to accept the doctrine of
SWM and try to reform the economic system so that it could satisfy all the underlying
assumptions mentioned above:

However, this attempt has witnessed a long history characterized by a mixture of

success and failure.
Moreover, su cient reform of the institutional and economic system built on the
ground of SWM would be a very costly task for both politicians and economists.

So they suggest another way to solve the problem, that is to totally reject the SWM
paradigm and shift to another paradigm that uses normative-stakeholder theory as the
core.

11. Summary
That brings me to the end of my presentation, but before we conclude, I would like to give
you a short summary of the given information.

Firstly, we investigate the reason why the firm exists. That is to minimize
transaction costs incurred during the production process.
From this ground, we review the theoretical background for the maxim SWM. Thank
to the market, the manager doesn't need to care about the preferences of her
shareholders, the only task left is to maximize profit (or shareholder value).
However, this theory has many flaws because its underlying assumptions are not
always valid in reality. The failures were so big that even the attempts to reform the
system in order to fit it with the theory haven't seen much success.
So Jones & Felps suggest a paradigm shift and highly value the importance of the
normative stakeholder theory.

12. Question & Discussion

Thank you very much for your attention, now it's the Q&A and discussion session. I'm
pleased to answer any question of yours.