Tuesday, August 19, 2008

Profit-maximization as the sole goal of a corporation

(Martin Wolf @ FT) What is the goal of the limited liability, joint-stock company, the core institution of the contemporary capitalist economy? What implications does the answer have for such a company's freedom to be “creative” in the way Bill Gates uses the term? The classic answer to the first of these questions, repeated often in these discussions, is that its aim is to maximise profits. This statement is not false. But it is vastly too limited. Here are ten points relevant to this theme.

First, one has to distinguish the goal of the firm from its role. The role of companies is to provide valuable goods and services – that is to say, outputs worth more than their inputs. The great insight of market economics is that they will do this job best if they are subject to competition. Profit-maximization (or shareholder value maximization, its more sophisticated modern equivalent) is NOT the role of the firm. It is its goal. The goal of profit-maximization drives the firm to fulfill its role.

Second, by creating a competitive market for corporate control, we more or less force companies to maximize shareholder value, or at least behave in ways that the market believes will lead them to do so. If companies fail to oblige, the company will be put “into play." Thus, in Anglo-American shareholder-driven capitalism, maximization of shareholder value (as perceived by the market) must perforce be the goal of the company. This is not the case in countries where a market in corporate control does not exist. In such countries, companies must earn a high enough return on capital to survive. But this need not be a shareholder value-maximizing return.

Third, a company is viewed in the Anglo-American world as a bundle of contracts. But companies are also social organisms created by a highly gregarious mammalian species with a unique capacity for large-scale co-operation over time and space. Companies have cultures and histories. For many of those most closely associated with them, they also have (and offer) a certain meaning. Committed workers in successful companies do not work in order to maximize shareholder value or even to earn the largest possible living. Indeed, it is impossible to direct most companies solely by the goal of profit-maximization. (Goldman Sachs may be an exception.) They have to be aimed at the intermediate goal of producing and developing goods and services that people want to buy and are worth more in the market than they cost to produce.

Fourth, the idea that a company is an entity that can be freely bought and sold is culturally specific. It is the view, above all, of Anglo-Americans. It is not shared in most of the rest of the world. The reason for this divergence is that, for many cultures, a company is viewed as being an enduring social entity. I once read that, for many Japanese, one can no more sell a company over the heads of its workers than one can sell one’s grandmother. In this view, goods and services can be bought and sold. Companies, like countries (or, as we all now agree, people), must not be.

Fifth, in this perspective, shareholders are not genuine owners. They contribute nothing of value to the competitive strengths of the firm, enjoy the benefits of limited liability and are well able to diversify the risks they run. They are merely an (ever-shifting) group of people with a claim to the residual incomes. Those with the biggest (undiversifiable) investment in the firm -- and thus the greatest exposure to firm-specific risks -- are not shareholders, but core workers. The interests of the latter are, therefore, paramount.

Sixth, the salient characteristic of the contracts inside the firm (that is between the company, its employees and, quite often, its suppliers and even distributors) is that they are relational. That is to say, they cannot be written down in any precise form. Companies are hierarchies in which people engage voluntarily. They necessarily work on the basis of trust in what is often a very long-term relationship: I work extra hard to meet a deadline now, in return for consideration when I need to look after my elderly mother later on. For many companies, trustworthiness is an essential ingredient in their long-term success.

Sixth, if companies can be freely bought and sold, relational contracts, which depend on continuing interaction among specific people inside the business, are hardly worth the paper they are (not) written on. Rational employees will act opportunistically, because they will always expect their company to do the same. The longer and more reliable relationships are expected to be, the less likely such opportunistic behaviour is to emerge.

Seventh, accordingly, capital-market arrangements (and associated views of the firm) that enforce shareholder value maximization may (I stress “may”) make companies work less efficiently than otherwise, in terms of their primary role, by precluding (or at least making far more difficult) a range of potentially valuable relational contracts inside the firm. At the least, such restrictions may have powerful effects on comparative advantage, by shifting countries away from those activities in which companies that benefit from long-term relational contracts are likely to be most effective.

Eighth, it is not necessarily even the case that companies which operate under the assumption that they can be bought and sold (like GM) will operate more successfully in terms of maximizing shareholder value than those which do not (such as Toyota). Toyota is a better car company than GM in almost all dimensions. The failure of Japanese capitalism to achieve the highest level of productivity and sustained dynamism may have far more to with repression of domestic competition in many markets for goods and, above all, services, rather than with the absence of an active market for corporate control.

Ninth, consequently the room for enduring divergence in the forms of capitalism is bigger than those working in the Anglo-American intellectual tradition appreciate. In particular, without an active market for corporate control, managements rule companies. It also acts as a trustee for a range of stakeholders, of which core workers are the most important. Because these companies cannot be forced to maximize shareholder value, they can indeed undertake a range of costly “charitable”activities, provided they do not threaten the company’s ability to survive.

Tenth, one of the most interesting questions over the next generation is whether the Anglo-American form of capitalism, which gives primary direction of companies to capital markets, will flourish and expand, or not. Some of the evidence on the (in)effectiveness of takeovers and the recent sad experiences in financial markets rather suggests not.

This is not to deny that such active financial markets bring big benefits, particularly in financing new companies and enforcing greater discipline on badly run businesses.

Anyway, the more “Anglo-American” capitalism becomes and so the more shareholder driven, the less “creative,” in Bill Gates’s sense, it is likely to be. Or, at the least, the less concerned with wider social results it is likely to be.

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