Fama, Eugene F., Contract Costs, Stakeholder Capitalism, and ESG (October 29, 2020)

Question 1

What is the main argument of Fama’s paper?

Answer 1

That contract costs explain why firms are best structured to maximize shareholder wealth, not stakeholder welfare.

Question 2

Why is maximizing shareholder wealth the optimal decision rule?

Answer 2

Because shareholders bear residual risk and have aligned incentives, while other stakeholders have fixed claims.

But the optimal decision rule remains max shareholder wealth, because:
- It aligns with how consumers and investors manage their own portfolios.
- Firms can’t know or cater to everyone’s unique definitions of “welfare”.
- Trying to do so creates Arrow’s impossibility issues (no consistent way to aggregate preferences).

Question 3

Why is the idea of maximizing shareholder wealth flawed?

Answer 3

• Different investors value ESG goals differently.
• It’s unclear how to balance tradeoffs between E, S, and G.
• It introduces major contracting problems between shareholders and managers.
• Votes or polls might help, but they bring their own issues and uncertainties.

Question 4

What role do contract costs play in stakeholder capitalism?

Answer 4

High contract costs make it inefficient for all stakeholders to influence decisions or agree on welfare-maximizing actions.

Question 5

How does Fama link his ideas to the Coase Theorem?

Answer 5

Stakeholder capitalism can be seen as a Coasian world where, if contracts were costless, firms would maximize total stakeholder wealth and split it via contracts.

Question 6

What does Fama say about ESG and externalities?

Answer 6

ESG activism may help, but markets alone can’t solve all externalities. Regulation may help, but is often inefficient.

Question 7

What is the “separation theorem” Fama refers to?

Answer 7

Individual firms optimize for shareholder wealth, while investors use their portfolios to achieve desired ESG exposure and risk-return preferences.