Stakeholder Theory Explained

Stakeholder theory states that the objectives of creditors, customers, employees and society as a whole should be included.

The stakeholder theory, put forward by Edward Freeman, links to corporate social responsibility but the main difference is that it starts from the world’s perspective rather than starting from a business perspective. It takes into account benefits of stakeholders as well as economical responsibility of the business towards its shareholders.

Stakeholder Theory

A primary goal of most firms is to maximize the wealth of their shareholders but shareholders are not the only stakeholders in companies. Suppliers, employees and consumers are also important stakeholders that need to be taken into account during the process of decision making.

Shareholder vs Stakeholder Theory

Milton Friedman: A company is beholden only to shareholders – that is, the main social responsibility of a business is to increase profits for its owners. Any diversion of company profits to social programmes, charity and other not-for-profit generating activities represented a tax on consumers and investors.

Edward Freeman: Shareholders are merely one of many stakeholders in a company. The stakeholder ecosystem involves anyone invested and involved in, or affected by, the company: employees, consumers, local communities, financiers, vendors, governmental agencies, and more.

Freeman’s theory suggests that a company’s real success lies in satisfying all its stakeholders, not just those who might profit from its stock.

Stakeholder Theory recognizes the existence of all groups and individuals who benefit from or are harmed by corporate actions. These stakeholders are actors who have an interest in the operations of a company because they are affected by it.

The theory suggests that it is necessary to take the wilder interests of all stakeholders into account.

Premises of stakeholder theory:

1. The corporation has relationships with many constituent groups (i.e. stakeholders that affect and are affected by its decisions).
2. Stakeholder theory is concerned with the nature of these relationships in terms of both processes and outcomes for the company and for the stakeholders.
3. The interests of all legitimate stakeholders have intrinsic value and no set of interests is assumed to dominate the others.

According to Freeman, managers are not only answerable to shareholders or stockholders; they have the responsibility to consider any group that is affected by the objectives of their business.

Freeman argues that in today’s world, business is not only about making profit. Businesses must portray themselves as ethical and socially responsible, and base their operations and objectives on ethics.

Stakeholder theory explains who are stakeholders and the link between stakeholders and firm goals. This theory helps businesses to understand the importance of relationships with stakeholders in order to deliver their services, and provides directions on how to make ethical decisions.

Descriptive, Normative and Instrumental Applications

Stakeholder theory has descriptive, normative and instrumental applications.

The descriptive level mainly describes the behaviors of firms, which is to enhance financial and social performance. It concentrates on organisational operations, describes what a corporation is through hierarchical positions, expected roles and responsibilities.

Normative approach examines the function of corporations and talks about moral and philosophical principles for operation and management of firms. Firms should care about shareholders but should also care about other stakeholders such as customers, employees and suppliers. It focuses on individuals and groups with “legitimate interests in procedural and/or substantive aspects of corporate activity”.

The instrumental implications suggest that conventional profitability goals of enterprises can be achieved if firms adhere to stakeholder principles.

Related: Check out more business ethics and Responsibility Theories

Criticism of Stakeholder Theory

Like any other theory, the stakeholder theory is not free from criticism.

It may be impossible for a business to meet the needs of all the stakeholders at the same time. It doesn’t suggest how businesses would rank the stakeholders in order to meet their needs.

The theory doesn’t mention how the business should analyze its stakeholders. Should a business focus only on living stakeholders or should it consider non-living stakeholders as well such as the environment?

Certain businesses (such as tobacco) however have prioritized their stakeholders amongst the others due to the dependency factor.

By meeting needs of other stakeholders like farmers, laborers in the supply chain, tobacco companies have somehow been successful in camouflaging the threatening nature of their products in the views of the consumers and the government.