(Illustration by Adam McCauley)
Luigi Zingales, a professor of finance at the University of Chicago Booth School of Business, studies corporate governance. His research asks how investors and other groups, such as customers and employees, convey their values and preferences to executives.
For most companies, meeting the different priorities of many constituencies can seem impossible. Milton Friedman, the Nobel Prize-winning economist and champion of the unfettered market, argued that companies should simply focus on their bottom line, maximizing profits to be distributed as dividends and used however shareholders wanted. But Zingales sees things differently.
In a new paper with his former advisor, Oliver Hart, a professor of economics at Harvard University and a Nobel laureate, and Eleonora Broccardo, a professor of economics at Italy’s University of Trento, Zingales weighs the effectiveness of two strategies that constituencies often employ to induce executives to do more than just maximize profits. The researchers found that socially and environmentally conscious investors can sway management and change corporate policy in ways that benefit the greater good—all while contributing to the company’s bottom line.
Using a theoretical model to compare two strategies, the researchers tested exit and voice, both shorthand for the types of pressures stakeholders can exert on a company. Whereas exit means “voting with your feet,” through divestment or customer and employee boycotts, voice refers to engaging with corporate management, usually through shareholder voting, to communicate preferences. Growing social and environmental concerns in shareholder activism have intensified pressures for investors to effect change. But what strategy investors should pursue to impact corporate outcomes has only recently come under scrutiny.
The researchers constructed a model that assumes that most investors are at least slightly “pro-social,” or socially responsible, and maintain “well-diversified” portfolios that include a variety of investments, and that shareholders will vote according to their preferences. Building on these and other basic assumptions, Zingales and his colleagues established that the voice strategy is far more likely than exit to achieve socially desirable outcomes. “Our finding that exit does not seem to work very well was not surprising,” Zingales says. “Perhaps the extent of our finding was surprising, since our result turned out to be even more extreme than what other scholars have found.”
The researchers use the example of environmental harm caused by pollution to better flesh out the incentives and costs of divestment campaigns and boycotts. Delving into a well-known case from 1984, when chemical company DuPont (now Dow Chemical) faced a choice between polluting the Ohio River with a toxic substance and investing in incineration, the researchers found evidence that the exit strategy did not achieve good results for the environment. Not only did exit fail to convince the company to pay for the cleanup, but also actors who were not interested in social welfare could undermine the exit strategy. Socially minded investors seeking to punish a company can sell shares, depress stock prices, and attract public attention, but an unintended consequence is that selfish actors will have new investment opportunities to purchase shares and drive up stock prices, thereby squashing incentives for executives to act.
For the researchers, the surprising result was that voice proved highly advantageous for promoting corporate change. “The world of Friedman is a convenient one, where you don’t need to know much. Only that more is better than less,” Zingales says. “We try to maximize profits and that’s it. But what if investors don’t like the way the company is maximizing profits?”
Demonstrating that most investors were willing to accept a slightly lower share price, as long as the social impact of their decisions outweighed the costs, the researchers upended conventional wisdom. “This paper provides a unique framework through which the debate on shareholder maximization versus stakeholder maximization can be resolved,” Amit Seru, a professor of finance at the Stanford Graduate School of Business, says. Investors achieved the socially optimal outcome by communicating and engaging with executives.
“The best way to make a difference is to engage, not divest,” Zingales says. “The challenge is that today, most stocks are owned by institutional investors, such as BlackRock, which makes it difficult to communicate preferences to a company. We need to put in place mechanisms to transmit these preferences from investors to companies.”
Eleonora Broccardo, Oliver Hart, and Luigi Zingales, “Exit versus Voice,” Journal of Political Economy, vol. 130, no. 12, 2022, pp. 3101–45.
Read more stories by Daniela Blei.