Competition among firms for investment funds and customers
Even without direct control of their corporation, stockholders (and the investment advisers, pension fund managers, and others hired to help them) have an incentive to monitor the corporation’s management in order to anticipate problems and search for constructive changes. Investors who are the first to spot a profitable new management strategy can buy stock early, before others realize the opportunity, and bid the price up. A rising stock price is both a signal of approval to good managers and an incentive to manage the corporation well. Conversely, when managers’ decisions are contrary to the interests of stockholders, the opposite occurs: the stock price will fall. Knowing that stock prices can plummet motivates stockholders (along with professional managers of stock holdings) to be the first to spot a problem with the company. This way they can dump their stock before everyone else does, and thus prior to the share price falling. Some investment firms even specialize in selling shares “short” (writing contracts to deliver shares of the stock later, when they expect the stock price to be lower than its current level) if they believe a company is overvalued on the market. So managers get constant feedback via stock price changes, which can be just as important as current profits to stockholders and boards of directors.
Similarly, consumers have an incentive to monitor the quality and price of the firm’s output. No one forces them to buy the corporation’s product, so if other firms supply superior products or offer lower prices, consumers can take their business elsewhere. Because investors are free to buy and sell the company’s shares and customers to buy its products or those of other firms, the ability of managers to benefit personally at the expense of either customers or stockholders is limited. While some managers are still able to enrich themselves at stockholders’ expense, at least temporarily, the recent cases of corporations like Tyco and Enron show that their actions tend to catch up with them.