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With an introduction by Markus Brunnermeier, Director of the Princeton Bendheim Center for Finance

On Thursday, October 8, Luigi Zingales joined Markus’ Academy for a lecture on “Which Capitalism?”

Luigi Zingales is a Professor of Finance at the University of Chicago Booth School of Business.

Watch the full presentation below and download the slides here. You can also watch all Markus’ Academy webinars on the Princeton BCF YouTube channel.

Executive Summary

Milton Friedman’s ideas have been at times a positive influence on capitalism over the last 50 years, but need to re-evaluated today. Writing in the New York Times in the fall of 1970, Milton Friedman wrote that “the social responsibility of business is to increase its profits.” Zingales argues that the ideas articulated in this hugely influential op-ed moved companies in the right direction at the time, but no longer serve society.

Zingales says Friedman’s “Separation Theorem” doctrine is more valid than its detractors claim, but more wrong than its supporters would like.  Zingales refers to Friedman’s doctrine as the “Friedman Separation Theorem” (closely related to the commonly taught Fisher Separation Theorem)—a theorem based on four assumptions that result in the idea that corporations can separate themselves from how company profits are redistributed once profits are passed onto shareholders.

The four parts of the theorem are: 

Assumption 1: Corporations are price (and rule) takers in a perfectly competitive environment.
Assumption 2: Corporations don’t produce externalities. If they do, the government alone can address those externalities.
Assumption 3: Corporate agents (individuals) only care about monetary payoff.
Assumption 4: Corporations always have complete contracts.

Challenging Assumption 4: Contracts are clearly not complete because shareholders are not the only residual claimants. When starting at a firm, not everything is ex-ante clearly contracted upon. The same is true for a marriage contract, Zingales notes as one example. He says companies should protect other stakeholders by contracting differently.

Challenging Assumption 3: It’s clearly false that corporate agents care only about monetary returns. For example, people give lectures for free and pursue jobs they enjoy even when they pay less than other opportunities.

Challenging Assumption 2: Corporate externalities like pollution, risk, and impact on the community are large. It is inefficient for companies to pollute first and then individual shareholders clean up afterwards. Zingales says it’s unfortunate that the Department of Labor is trying to limit corporations from expanding their mandate by prohibiting asset managers from considering any factor other than financial return.

Challenging Assumption 1A: Existence of monopolies like Google disprove Friedman’s belief that all corporations are price takers in a perfectly competitive environment. Further, Google’s “social responsibility” likely extends beyond maximizing profits.

Challenging Assumption 1B: Corporations do not, as Friedman argued, aim to make money while also conforming to basic rules of society. Research on regulatory capture shows that corporations aim to and succeed in shaping regulation in their favor, not society’s favor. They commit a huge lobbying budget to change the rules and the law.