1.9 The Goal of the Firm

Here, we will discuss the main objective or goal of most companies. In the past few sections, we have covered topics related to how stock prices are determined by supply and demand in financial markets and how new information can affect the demand for stocks and subsequently change stock prices. It is easy to think of cases about how management decision-making will lead to new information. Think about cases when a firm releases a new product or announces the acquisition of another competing company. These decisions will undoubtedly affect the stock price of the firm. Traditionally, the goal of the firmTraditionally, the goal of a firm is to maximize shareholder value. has been to maximize shareholderAn individual (or entity) that holds a share or fraction of ownership in a particular company. value. This is usually accomplished by profitable decision-making by management, investing capital into projects that will increase the firm’s stock price, and avoiding those investments that cost more money than they bring in. Therefore, the prices produced in financial markets become an important signal about whether the firm is achieving its goal of maximizing shareholder value since the stock price reflects the value of each individual share of the firm.

Maximizing shareholder value might mean different things to different companies, depending on the type of company. A privately held company (a company with shares that are not available to the public) may define value differently than a publicly held company (a company with shares that are available to the public). Take, for instance, a private company that is made up of a few owners from a particular family. Privately held family businesses likely place more value on keeping the business in the family and will make decisions with that in mind. For publicly traded companies, the most reasonable and reliable signal of whether management is indeed maximizing shareholder value is simply the firm’s share price. In cases where management does not use the company’s resources in a way that maximizes shareholder value, the price of the company’s stock will decrease in an efficient market.

While the traditional goal of the firm has been to maximize shareholder value, there has been a movement over the last few decades to define an alternative goal or objective. During the summer of 2019, 181 leaders of some of the largest and most recognizable companies released a statement on a new “purpose of a corporation.” In particular, these leaders, which make up part of an organization called the Business Roundtable, stated that not only should the firm benefit shareholders, but the firm should also consider all other stakeholders of the firm when making decisions. These stakeholders might include customers, employees, suppliers, and communities where the firm is located. These two differing ideas about the goal of a firm are sometimes referred to as “shareholder capitalism” and “stakeholder capitalism,” respectively. While a careful analysis of the advantages and disadvantages of both of these firm objectives is outside the scope of this text, the economic implications of adopting either of these two types of capitalism are likely to be important for years to come.

In the next section, we will discuss a few issues with the goal of companies being to maximize profit or maximize shareholder value.