Alex Edmans, a finance professor, is having a bit of a moment at the moment. His book Grow The Pie that I’m discussing in two posts is a very useful addition to the field. This post will outline the core points of Edmans’ work. The other post will get into a few more finicky points including why no one likes finance scholars and why it is entirely their fault. Today, I’ll talk about Edmans’ three principles to guide decision-making.
Growing the Pie
Edmans talks about growing the pie. In effect, this is looking for decisions that make the world a better place. I’m all for it. His advice is very good in that we need to stop thinking of life as being one full of games where there are just winners and losers. Most of life isn’t like this, see The Trump Fallacy.
Although a focus on growing the pie is valuable, all of us find this hard to remember at certain times. Edmans himself even gets into problems. He is discussing why people might want to invest in socially beneficial companies but he himself falls into pie-splitting terminology.
Even though it’s shareholders who ultimately pay the higher wages [of employees], many only want to earn returns from companies whose employees are able to live a dignified life.Edmans, 2021, page 360
Critically the next line shows the trap that Edmans has fallen into.
Moreover, these higher wages typically grow the pie by improving retention and motivation, and aren’t at the expense of long-run profits.Edmans, 2021, page 360
Edmans is right. Shareholders shouldn’t have a pie-splitting mentality. They aren’t just giving employees money out of their own pockets as charity. They are paying higher wages to have a better firm. If higher wages can grow the pie then shareholders don’t necessarily ultimately pay for the higher wages as they may get more money back later.
Indeed, soon after he says:
Since the pie-slipping mentality is prevalent, many readers may assume that pay and profits must be at the expense of other stakeholders.Edmans, 2021, page 382
To be clear I don’t see this as a big criticism of Edman’s work. We all fall into this trap. It can sometimes be rough for all of us to break the idea of pie-splitting but I agree with Edmans that we should try.
Three Principles To Guide Decision-Making
Given that Edmans is thinking about companies being run for the benefit of a variety of stakeholders he has to go beyond just saying ‘does this plan make more money than any alternative?’ He sets out three principles to guide decision-making. A company should only take a decision when the following principles are satisfied.
The Principle of Multiplication
Does the action to be taken deliver greater benefits to stakeholders than it costs? This gets rid of inefficient ideas that might benefit one group but not society collectively. Edmans wouldn’t be in favor of capturing more funds for shareholders if this was at expense of other stakeholders collectively. Exploiting natural resources might make money for a firm but this could come at greater costs to society (widely defined). Unsurprisingly, Edmans isn’t for such inefficient exploration of resources or exploitation of other stakeholders. Things should, after all, grow the pie.
The Principle of Comparative advantage
To counter Milton Friedman’s argument that firms should just pass money to shareholders rather than do public good works Edmans notes that comparative advantage can be a justification. Some people/organizations may be able to address problems much more efficiently and effectively than others. The decision-maker should always ask, ‘is this something we can create more value doing than anyone else can?’ I.e., do we have a comparative advantage in doing it? Where you (person/firm) have such an advantage it makes sense for you to do it rather than pass funds for someone else to do something with those funds given they are less well-equipped to use them efficiently.
The Principle of Materiality
In the stakeholder literature materiality means something a bit different to the accounting use. Accountants use materiality to mean something has a meaningful magnitude. Edmans, and colleagues, use materiality to mean whether the stakeholders have a reasonable connection to the company. This can be because the stakeholder can impact the business, e.g., customers (business materiality) or because the company should have a concern for the stakeholder (intrinsic materiality). E.g., people who live near where the firm is extracting resources have intrinsic materiality to the firm. Basically, you can’t worry about every possible stakeholder all the time so you should ask ‘are these stakeholders relevant (material) to this decision?’
Overall Edmans’ basic ideas make a lot of sense.
Read: Alex Edmans (2021) Grow The Pie: How Great Companies Deliver Both Purpose and Profit, Cambridge University Press, https://www.growthepie.net/