This essay is based on the working paper “What Do Shareholders Want? Consumer Welfare and the Objective of the Firm” by Keith Marzilli Ericson.
There is a long-standing debate about what firms should maximize: is the social responsibility of businesses to increase profits for shareholders, or do firms have a duty to consider the interests of other stakeholders? Yet even more basic is the question: What do the shareholders who own the firm actually want?
While economic theory typically assumes that shareholders want the firm to maximize financial value, shareholders may have a variety of goals, such as wanting firms to pursue ESG (environmental, social, and governance) objectives.
Consumers are a key group missing from typical ESG or corporate social responsibility measures, even though promoting consumer welfare is arguably a social objective. Consumers are closely related to a firm’s core business, and while firms may or may not have a comparative advantage in promoting other goals, promoting consumer welfare is undoubtedly a competitive advantage for firms.
Shareholders care about how firms treat consumers for two reasons. The first is simple self-interest: shareholders are consumers themselves. Second, shareholders may have altruistic motivations and care about others.
I focus on how shareholders want firms to set prices when they have market power. Lower prices are a unique technology for promoting consumer welfare, and economists understand a lot about this technology. While setting markups above the competitive price transfers money from consumers to shareholders, higher prices prevent some valuable trades from taking place, reducing the overall size of the pie.
Price reductions near the profit-maximizing price have limited impact on profits but substantial benefits for consumers. At the profit-maximizing price, small price decreases (or increases) don’t impact profits much. With a lower price, the firm gets less revenue per sale but sells more. The net gain to consumers is larger than the loss in profits.
The key parameter the firm needs to know is the tradeoffs shareholders are willing to make between profits and consumer surplus. If shareholders value consumer surplus (which translates to lower prices and better value for consumers) and profits equally, they will want the firm to set price equal to marginal cost. On the other end of the spectrum, if shareholders do not prioritize consumer welfare at all, there is no concern for consumer surplus.
Optimal pricing formulas can be adapted to account for how shareholders want to treat consumers using the “weight” placed on consumers—with weight indicating a prioritization of consumer welfare and the absence of weight indicating a disregard for consumer welfare. Shareholders that care about consumer welfare prefer firms to set a lower markup.
Placing even a small weight on consumers yields significant social benefits. Using the key parameter—shareholders’ desired weight on consumer surplus—we can estimate the impact of implementing this weight in optimal pricing. I calculate changes in quantities sold, prices, profits, and consumer surplus in different industries.
There are gains to even small price reductions. Suppose shareholders are indifferent between increasing profits by $1 or consumer welfare by $100—a relatively low 0.01 weight on consumers. Then, when implementing shareholders’ preferences, prices would decline by about 0.5% to 1% compared to the profit-maximizing price, depending on industry. While profits would decline slightly, consumers would gain about 200 times as much as shareholders would lose in profits.
To determine the weight that shareholders would like to place on consumers, I first use data from equity holdings and consumption, assuming they hold a diversified portfolio and consume a wide array of goods.
The weight a shareholder places on consumers depends on the ratio of their consumption share to equity share. For instance, take a representative individual from the top decile of income, which owns about 71% of all the stock in the economy and consumes about 22% of all that is produced in the economy. Thus, for every dollar the firm transfers to consumers, people in this top decile of income pay $0.71 of it from lost profits but gain $0.22 from lower prices. They would thus be indifferent between increasing profits by $0.31 (0.22/0.71) or consumer welfare by $1, implying a weight on consumers of 0.31. (Of course, the desired weight may be even higher if the shareholder is altruistic).
Constructing weights for more detailed demographic groups, I show that the weights are substantial for most shareholders as well as for the median share of equity held.
Finally, I use survey experiments to directly elicit shareholders' desired weights on consumer welfare. I ask how shareholders would vote on resolutions giving strategic guidance to firms about what objective function to pursue. These types of resolutions give general guidance to firms and do not require shareholders to have specific knowledge about the relative costs and benefits of particular actions.
In an approximately representative sample of Americans, I show that the median weight on consumer welfare is about 0.44. The weight is slightly lower for those who own stock (0.27) but still above zero. Most of the participants (93%) vote for firms to place some weight on consumers and not solely maximize profits.
Overall, shareholders are generally willing to forgo some profits to provide greater benefits to consumers. Firms have a comparative advantage in promoting consumer surplus by lowering prices in imperfectly competitive markets, where price decreases yield substantial gains for consumers relative to their cost in profits. While this paper focuses on how shareholders want firms to benefit consumers by setting lower prices, a similar logic applies to other actions that deliver less in profits than they cost consumers, such as avoiding hidden add-on fees and difficult-to-cancel automatic renewals.
Read the full paper here.
Keith Marzilli Ericson is a professor of markets, public policy, and law at the Boston University Questrom School of Business.
This essay is part of the Corporate Governance Research Brief Series. Research briefs highlight research with policy implications for the regulatory systems that impact corporations.
