Profit-maximization as the sole goal of a corporation

By Martin Wolf

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.

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.

Comments

[Michael F. Martin]

Brilliant. I believe some empirical studies on how founder-managed companies (within Anglo-American markets) tend to outperform other companies might provide a nice independent confirmation for some of these points. Like monarchies, the disadvantage to founders staying in control is often a bloody succession. But clearly those costs should be weighed against the loss of institutional culture that a more vigorous market for corporate control provides. What is so helpful about these points, however, is that they really help to see where tradeoffs are being made right now. Not enough people think about the difficult-to-measure social capital built up among the employees and customers at certain corporations -- much less use it as an argument to justify strategy with uncertain outcomes to the board, analysts, and investors. We lost more than money when the employee of Bear Sterns dispersed to other financial institutions.

[Tracy W]

Thus, in Anglo-American shareholder-driven capitalism, maximization of shareholder value (as perceived by the market) must perforce be the goal of the company.

Unless we are talking about one of the numerous privately-held companies.

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.

Is there any evidence that a company that is concerned with wider social results therefore better for society than a company that just focusses on narrow social results?
Democratic governments are inherently concerned with wide social results, but stuff-ups by them are common. I don't see that a company, regardless of how it is owned, will do any better.

Indeed, I am extremely doubtful about general benefits of any organisation, for-profit or non-profit, that tries to achieve "wider social results".

[fh]

It doesn't make any difference what the goals of a corporation in the USA are. The poor quality of government ensures that Schumpeter still applies, with booms and busts at ever shorter intervals. Why? Because instability and market fluctuations are the right environment for US investment banks, hedge funds and private equity to enable them to make money.

Incidentally, re point 4 of MW's article, the German AWG (Aussenwirtschaftsgesetz) should be coming into force v ery soon. Broadly speaking, that law is designed to make it much more difficult for foreigners to take over German firms.

[martin wolf]

Thanks for thoughtful comments. This is, of course, just a think piece about the nature of contemporary capitalism (as, indeed, were my other pieces). I don't think we can talk about "creative capitalism" - a pretty empty concept, in my view - without understanding what capitalism is.

I agree with Tracy W that private companies are an entirely different kettle of fish. Their owners can do whatever they like with them, within the law, so long as they cover their costs. As to whether it makes sense for companies - or indeed any institutions - to be concerned with "wider social results", I sympathise with Tracy W's scepticism. But that was the starting point of this entire debate, wasn't it? I have (I hope) one final post to come, which discusses this a little bit more.

[fh]

Regarding point 5 in MW's piece and the role of shareholders (i.e. their role as providers of capital).
Capitalism depends on the availability and provision of land, labour, capital and "entrepreneuership" in order to function and survive. It is the regular destruction of capital in the USA which is causing so much damage to the US economy, and the global economy as a whole.

Schumpeter of course forecast that capitalism would self-destruct as a result of its excesses, and wrote that it would be succeeded by socialism! Of course, the S-word is never mentioned in the USA, but many of the debts caused by the subprime disaster ARE being "socialised" i.e. the US taxpayer and holders of US dollars (a steadily depreciating currency in recent years) are paying for the "excesses" of US capitalism.

[n p chekkutty]

the German AWG (Aussenwirtschaftsgesetz) should be coming into force v ery soon. Broadly speaking, that law is designed to make it much more difficult for foreigners to take over German firms.

FH, Can I take it that this is a major step in the direction of insulating the German economy from the global one? Put it more clearly, is it an indication of the German aloofness or maybe, a new surge of protectionism in one of the most important economies in the rich world?

And one more question: Exactly against whom are these measures aimed at? Is it the rest of west which has always been an alley since the second world war, or is the new forces from the developing world that the law would try to keep out? I have seen quite a bit of parochialism in some European countries of late, like when an Indian steel firm, Mittal, made an effort to buy up the French steel-maker, Arcelor.

[Martin Wolf]

fh seems to be confusing balance sheet effects with genuine destruction of capital (i.e. wasteful investment). There is waste in all economic systems, but the biggest destruction of capital in the last century, in peace time, occurred in the Soviet bloc. Today, I would guess, that the biggest waste of capital in the world is in China, a country with a national savings rate of about 60 per cent of GDP and limitless quantities of cheap and hard-working labout that still manages to grow "only" 10 per cent a year and is also investing about 10 per cent of GDP a year in foreign assets with, as fh suggests, negative real returns to the Chinese.

[n p chekkutty]

MW:but the biggest destruction of capital in the last century, in peace time, occurred in the Soviet bloc.

Is it right to compare the command economy of the Soviets or China with the democratic system where the market economy has been in full flow?

Perhaps it would be more correct to describe the destruction and wastage in Soviet bloc as creative destruction because in the past decade Russia has grown at least ten fold compared to the time Putin took over.The growth should seem impressive in the light of the kind of problems they faced at the time of the collapse of the earlier system.

Same should be the case with East Germany. It was a mess when integration took place but we do not hear the same complaints we used to hear in the mid-nineties about the economic costs of integration.So perhaps, there is much substance in what fh says, that the US, in spite of its clear advantages, is making a mess of things for themselves and others.

[Jeff Mowatt]

Dear n,p,

I'm glad someone brought up the subject of the former Soviet bloc because that's where we went with the idea of reforming capitalism some years ago. 1999 in the first instance, to leverage a development project, after the Defense Enterprise Fund and just before Putin and the FSB took over, with a proposal for a model based on social capitalism principles.

If you've been following recent news on Georgia, which is difficult to escape right now, you'll know a lot of attention is being given to the vulnerability of the Crimean peninsular and the repatriated Tatar minority in particular.

Here my colleague and founder discusses the concept of reformed capitalism with the leader of the Crimean Tatar diaspora in Washington. This project, above all was one intended to broker peaceful co-existence in the knowledge of potential destruction . It should illustrate most of all where we see the ultimate value of the kind of CC which goes far beyond our perception of CSR.

[fh]

MW. I didn't say that the US was the biggest destroyer of capital, but the fact that the US economy is the biggest in the world gives cause for alarm as the fallout spreads globally when there is massive destruction of capital in the USA (subprime). No doubt you are right that the Chinese are saving too much and investing too much in paper - risky stocks - and don't seem to be savvy enough to take their profits and exit before the bust. Seriously, one wonders if it is humanly possible to run an economy which is in a transitional stage from a command economy towards some semblance of a free market economy? I venture to say that China should opt for the social market economy model (Ludwig Erhard's model) which ensured that Germany managed to rebuild its infrastructure, and the rest of its economy post-WW2 WITHOUT A REVOLUTION occurring or massive civil unrest.
I think this is an area where MW and I should just agree to differ.

n p chekkutty. This is the link to the FT Deutschland item about the AWG (which is, afaik, no longer a sister paper of the FT London but was sold to a German buyer. Am I right?)
You may have to get someone to translate it for you, but I imagine that MW knows German...

http://www.ftd.de/politik/deutschland/:Au%DFenwirtschaftsgesetz_Bund_ignoriert_Kritik_an_Staatsfondsplan/397229.html

My opinion is this:
Germany is always a bit behind the times, so that hedge funds, private equity etc happened in the USA and the UK first. In particular the SPD party (of Gerd Schröder) did not like what they saw - the job losses involved in buyouts, splitting up companies, and re-floating the parts. Franz Müntefering (deputy German chancellor in Schröder's govt) called hedge funds and P/E "locusts" Heuschrecken early in 2005. And that name has stuck, it's become a part of German economic history. But it also spurred sleepy German companies to ACT to protect themselves, to do the restructuring themselves, to divest less profitable activities and float them on the stock market. And to ensure that this was done "socially" (i.a. with a minimum amount of job losses).

The result is that many well-known German Dax companies are now in very good shape, and quite a few excellent new German firms now exist as a result of "spin-offs": some of them are world leaders in their sectors. They have been a bonanza for people who bought their shares. ^German companies also realized that they have to have a much more generous dividend policy otherwise their conmpanies' shares remain undervalued and of course, a target for "locusts"...and also that having a "core" of longterm investors who can be relied on to hold their shares, is an important part of the strategy to fend off any takeover attempts. Investors in Dax, MDax etc stocks have seen their dividends increase by as much as 30-40% in a single year.

Why the AWG, np? Well, Germans have seen the UK economy become a "hollowed out" one - the auto industry, shipbuilding, hardly exist any more; GEC (once the no. 1 firm in the FTSE) no longer exists. ICI (Imperial Chmical Industry) another huge UK company shrank massively and was sold off to ...Norway?
And the once great civil engineering company Wimpey is now reduced to a house-builder, suffering from the construction slump in the UK.

When German managers look at the US auto industry, they have nightmares at the thought that such a fate could overtake German car giants like VW, BMW. That's why Porsche and one of the German states (Länder) fought tooth and nail to acquire the VW majority and will never let it go. The same applies to many other large German companies.

P.S. Yes, Mittal - but in my opinion, he acted just in time to get Arcelor.
I think Sarkozy has also tightened up against outside takeover attempts. I know Mittal Steel from the time when it bought a steel mill in Temirtau (in Khazakhstan)...

[fh]

My previous mail: line 5 shd read
"an economy OF OVER ONE BILLION PEOPLE which is...."

Sorry for the omission

[Martin Wolf]

Russia hasn't grown anything like 10-fold since Putin took over. Real growth has been about 6 per cent a year, if I remember correctly: so you can do the maths easily. Actually, for what it is worth (not very much, I agree), Russia's measured GDP is just about back to where it was in 1990. I think you may be confusing real growth with growth in nominal dollars. But that merely reflects the fact that the rouble overshot downwards massively in 1998 and 1999.

I really don't think that a 74 year detour, from which Russia emerged a basket case, can be called "creative". It is worth remembering that Russia was the fastest-growing large economy in the world immediately before WWI. So if it had not been for the Soviet experiment, Russia would almost certainly be a rich country today, which it is not(particularly if you ignore the oil and gas windfall). This also ignores the gigantic human and political costs of the Lenin-Stalin experiment with totalitarianism, from which Russia has not, alas, recovered. It may never do so.

Also, no, I don't think fh is right on the US. The US has always been a boom-bust economy and it still is. It is after all a capitalist country. Just as it is senseless to expect Germany to become the US, so it is senseless to expect the US to become Germany (as I discuss above). But the US has been the preponderant source of global economic innovation since the late-19th century and particularly since WW II. Among large countries, it also has much the highest average income per head. The US is the global economic frontier. One has to be blind not to see that it has been astonishingly successful.

[Tracy W]

Capitalism depends on the availability and provision of land, labour, capital and "entrepreneuership" in order to function and survive.

Which economic system doesn't? I have a hard time to imagine a way of getting food into people's stomachs without using any single one on your list. Even hunter-gatherers make tools for hunting, trapping and gathering food (eg digging tools, baskets for carrying), and of course need land to hunt and gather on, and labour to do so, and someone originally has to have ideas like "let's hunt some deer today" or "time to move on to a new water supply".

It would be more precise to say that humans depend on on the availability and provision of land, labour, capital and "entrepreneuership" in order to function and survive.

It is the regular destruction of capital in the USA which is causing so much damage to the US economy, and the global economy as a whole.

Is the USA destroying more capital than other countries? Than which other countries? How are you measuring destruction of capital anyway? What is your counterfactual by which you are arguing that the global economy is being damaged, given that the world is richer this century than it has been at any time in its past?

[Martin Wolf]

In a final response to fh, yes, we should largely agree to disagree. The German social market economy is fine, for Germany. But there was never a chance of a revolution in Germany after WWII. You may remember that Germany was a defeated and occupied country. The US was not about to let it join the Soviet bloc!

Interestingly, all of continental western Europe did sensationally well in the 25 years after WW II, though they had somewhat different social and economic systems. I would argue that what they had in common were liberalisation, integration of the European and OECD economies, and catch-up on US technology.

China cannot be Germany, either. It is far too different. As to "hollowed-out" economies, I am quite happy with mine. We call it specialisation in line with comparative advantage. As others have pointed out, Germany has a fairly successful economy, but no more so than a number of other western economies.

Anyway, enough on these subjects, for now.

[Martin Wolf]

Sorry, I forgot to add something, which is on the lines of Tracy W's comment. The subprime crisis is not destruction of capital. It represents a big balance sheet adjustment. It is painful because the balance sheets involved include those of the financial system. But when the prices of houses go below the value of debts, there is no destruction of capital. The houses are still there, after all.

Balance-sheet effects are important. But they are not a destruction of capital. Destruction of capital occurs when there is sub-normal (even negative) returns on capital. In this case, the destruction (or waste) of capital consists in building houses that are subsequently worth less than they cost to construct.

[Tracy W]

And to ensure that this was done "socially" (i.a. with a minimum amount of job losses.

You are talking about a country that in 2007 had the third highest unemployment rate in the OECD. (http://stats.oecd.org/WBOS/Index.aspx?QueryName=251&QueryType=View&Lang=en) Possibly there was a minimum amount of job losses, but there also appears to have been a shortage of job creation in Germany compared to many other OECD countries.

The USA may or may not be destroying physical capital (you haven't provided any data on this point for any country), but Germany appears to be destroying human capital.

I don't see any reason why any developing country in the world would chose the German "social market economy model" model over the US one, or the Australian one, or the Scandanvian one, or the Japanese one, or the Irish one. After all, all those countries managed to develop without a revolution occurring in the process or massive social unrest. (The Irish did revolt but that was earlier against the British government.)

[n p chekkutty]

MW:Russia hasn't grown anything like 10-fold since Putin took over. Real growth has been about 6 per cent a year, if I remember correctly: so you can do the maths easily.

I am not going into an argument with a veteran economist like Martin Wolf on the figures with regard to Russia's growth. But I find that my figures were correct, on cross checking.

According to a report published in the major Indian newspaper, The Hindu, dated August 4, 2008, the Russian economy which was at $200 billion ten years ago, crossed $1.4 trillion in 2008. its per capita GDP quadrupled to $7000 in this period.

Of course this growth includes its oil and gas revenue too. But why should Russia count this revenue out while all others including the US count their oil revenues in GDP?

[Martin Wolf]

As I said, the huge rise in Russian dollar GDP is mostly because of the nominal appreciation of the rouble, not real growth. The appreciation was itself largely the inevitable consequence of the overshooting after the 1998 devaluation, plus the benefit of large oil and gas revenues. Figures for changes in national income in a foreign currency (the dollar) don't mean anything very much. As I said, you are confusing real growth with growth in nominal dollars.

[Doug]

So brilliant it needed to sixth points to contain it. Peerless thinking, improvable editing.

[Doug]

Two sixth points. More evidence of Muphry's law.

[Doug]

The economic efficiency of a firm depends on the role, not the goal, as you've laid them out. From a social welfare perspective it seems (unless I'm just still stuck in the old model) that the test of proper governance toward the proper goal would be how well the customer is served plus, I suppose, the value of any philanthropic activity. Toyota is a great example of how non-anglo-american governance is superior to anglo-american governance. Companies like Apple and Google, though seem to me to be counter-examples.

Feel free to delete the two obsolete comments of mine just above.

[Jes]

Profit Maximization - the logical optimization of this is to completely ignore all morality and ethics, which in a vacuum might be fine, but as a practical reality of being embedded in a larger society is self-evidently false - sociopaths need not comment.

Like most things, reality doesn't allow our simplistic, one-dimensions theories of the world to survive long without us needing to lie and obfuscate. Profit maximization is one of those simple-minded theories. Typical of academics, amateurs and failed businessmen.

One company that *didn't* have absolute profit maximization as a corporate objective was Hewlett-Packard. From what I've seen lately the current company is largely ignoring or has forgotten the original intent of the original Corporate Objectives. The original list, created by Bill and Dave, was Profit, Customers, Field of Interest, Employee, Community. I'm forgetting some of the last ones - I haven't worked for HP in 10 years. If you look at the current list you can see they've muddled it in typical committee fashion. No longer anything about what the priority order is. Utterly vague and unusable at an employee level.

http://www.hp.com/hpinfo/abouthp/corpobj.html

The way Bill and Dave designed it and intended it to be used was as tiered buckets: when you've satisfied the highest objective, you can then move to the next one done as *decision criteria for what you are doing now*.

The first on the list *is* profit but if you read the accompanying description under profit carefully it said "profit __sufficient__ to __satisfy__ obligations to shareholders, *and to carry out the remaining objectives*" or equivalent, with my emphasis on 'sufficient' and 'satisfy'. The key here is that 'sufficient' and 'satisfy' (or technically 'satisficing') is not the same as 'optimizing' or 'maximization'. Further the explicit listing of "other objectives" needing to be considered is significant. This worked very well for Bill and Dave while they were alive. Since their deaths it's been another matter (the split, Carly, et al.).

The history of US corporations generally suggests that it's only the leadership that makes the essential difference. The "organization" isn't fundamentally able to pull off what the founder or charismatic leader can. Ever. This goes for governments also - many empires have fallen with the death of a single man even where there was an heir.

Soviet Union: not really comparable to the corporate example - read Mancur Olsen's 'Power and Prosperity' on this.

[Walt French]

A fun post, but why is it axiomatic that the goal of a company is profit maximization? Certainly a private corporation is run for the benefit of its shareholder but would be expected to supply all sorts of non-profit benefits -- perhaps, ego gratification/publicity, amplifying one's notion of self-worth, service to the community, etc. -- as the shareholder wants.

And modern financial economics seems to have moved almost entirely to "behavioral" models and analyses which explicitly reject Homo Economicus -- Economic Man who calculates the price of everything without any other values -- as being anything other than a quirk in practice.

One point which illustrates the fallacy of "profit maximization" being the sole goal of a corporation: any experience with modern investing provides lots of opportunities, chiefly leverage, for maximizing profit by actually increasing the risk of catastrophic failure (from which the shareholders can walk away) but with a fantastic payout if the stars align right. THAT's obvious profit maximization, but seldom seen in practice (outside of Wall St firms). If 90% of American corporations DON'T maximize expected profits, but instead go for stability, long-term growth, etc., how can anybody assert that profit maximization is the complete cultural norm?

[Tracy W]

which explicitly reject Homo Economicus -- Economic Man who calculates the price of everything without any other values -- as being anything other than a quirk in practice.

Did Homo Economicus ever calculate the price of everything without any other values? I remember my Econ 101 days and it started off with the idea of utility, which is the thing that Homo Economicus tries to maximise. (Translated into real human terms, utility is just a placeholder for all our different needs and wants, physical, social, spiritual, it's useful in economics because it gets you the idea of marginal utility). Then we had Robinson Crusoe economics, with Homo Economicus in an economy of one, trying to decide how much of his time to allocate to different forms of food collection, then we had simple trade models based on barter, only after that did we move onto maximising utility with prices.

THAT's obvious profit maximization, but seldom seen in practice (outside of Wall St firms). If 90% of American corporations DON'T maximize expected profits, but instead go for stability, long-term growth, etc., how can anybody assert that profit maximization is the complete cultural norm?

Because profit-maximisation as a goal doesn't demand any particular risk-return tradeoff. Just because something maximises expected profits doesn't mean it maximises profits adjusted for the shareholders' and managers' risk aversion.

[Martin Wolf]

I am not going to get involved in the debates any more, though I am pleased to see some people are at last attending to my arguments. But I don't think there are two sixth points. The fifth point required two paragraphs. So the second of the paragraphs is intended to explain how core workers, in particular, relate to the firm.

For those interested in my views on the social and political context of profit-maximisation (and some seem to be interested in this theme), may I refer them to another of my posts in this forum: http://creativecapitalism.typepad.com/creative_capitalism/2008/08/what-makes-prof.html