What shareholder activism and lighthouses have in common

In economics, we categorise goods as being either excludable or non-excludable. Goods are excludable if a person can be prevented from having access to them (and therefore benefiting from them). Access can be prevented through laws (property rights) that define who can access the good. A common form of access is a price - everyone who is willing and able to pay the price, can purchase the good. Goods are non-excludable if, when they are available to anyone, then they are available to everyone. In other words, there is no mechanism for preventing any person from benefiting from the good, even if they haven't paid for it.

Non-excludable goods present a problem for a market economy, because if no one can be prevented from benefiting from the good even if they haven't paid for it, then it would be difficult for any private firm to produce the good for profit. The problem here is that some people will be free-riders - people who benefit from the good without paying anything for it. It would cost a private firm to provide the good, but if few people are willing to pay for it (because they can free ride instead), then the firm may not even be able to cover its costs. The good would then not be provided - this is an example of market failure.

This is the case for public goods (goods that are non-excludable, but also non-rival, meaning that one person's use of the good doesn’t reduce the amount of the good that is available for everyone else). A classic example of a public good is a lighthouse. The light from a lighthouse is available to every ship if it is available to any ship (it is non-excludable), and one ship benefiting from the light doesn't diminish the amount of light available to other ships (it is non-rival). However, because the lighthouse light is non-excludable, it would be difficult for a private lighthouse firm to operate, because ships could easily free ride. That is why lighthouses were typically funded by the local government, often through taxes or levies on ship traffic.

Another example of a public good with a free-rider problem is shareholder activism, as explained in this article from The Conversation last year, by Salvatore Ferraro (RMIT University):

Shareholder activism... involves shareholders directly engaging with directors and executives of companies to effect change from within.

To date, little activism has been motivated by altruistic purposes. That’s partly to do with a fundamental problem that limits the ability of activism to influence corporate behaviour for non-financial reasons.

Economists call it the free-rider problem. In essence it’s the problem of individuals having little incentive to contribute to a collective resource when they can enjoy its benefits even if they don’t.

How this applies to shareholders was first outlined by Harvard academics Adolf Berle and Gardiner Means in their seminal 1932 book The Modern Corporation and Private Property.

Ownership of public corporations is generally diffused between a significant number of shareholders. Individual shareholders have little incentive to monitor senior management, because of the cost they bear while others reap benefits.

So, while shareholders (and society, depending on the proposal) could benefit from more shareholder activism, most shareholders are free-riders - preferring to receive the benefits of activism, without incurring any of the costs. Because shareholder activism is also non-rival, it is an example of a public good.

Ferraro's solution to the free-rider problem in shareholder activism is:

Big institutional shareholders in particular could be more active in ensuring boards have skilled, competent directors. They could also foster a culture of openness by supporting directors to challenge senior management without fear of putting their tenure at risk.

The problem with Ferraro's solution is that even big institutional shareholders have an incentive to free ride, unless the benefits of activism are so large that they outweigh the institutional shareholder facing all of the costs of engaging in the activism themselves (which could be true, and indeed we do see examples of activist institutional shareholders). However, that won't work where individual institutional investors have only a small stake in the company. And even if it does work, the activism will likely be limited to proposals that benefit the large institutional investors (and not necessarily those that benefit smaller shareholders, or society more generally).

In such cases, we need some other mechanism, such as an independent shareholder activist organisation that can act on behalf of all shareholders. For instance, New Zealand has the New Zealand Shareholders Association. However, these organisations are currently limited by their voluntary membership. If we were serious about encouraging shareholder activism, we would need to fund it in the same way as a lighthouse - taxes or levies on shareholders, used to fund an activist shareholder organisation.

Would that lead to the 'right' amount of shareholder activism? That depends on what you think the right amount of activism is. One thing is clear though - free-riding is not helping the cause of shareholder activism in the status quo.