Profit Versus Value

Are corporations expected to be socially responsible actors? Or are they purely market players, expected to play by the rules of the game but seek no benefit outside their own bottom line? Milton Friedman believed that “corporate social responsibility” was a wash, little better than fraud. Specifically, he believed that “the social responsibility of business is to increase its profits.” Only in this manner would a given business be able to expand and survive without “defrauding” its owners. While Friedman’s reasoning is sound, his answer (exclusive focus on profits) is too simplistic for the modern business environment.

Friedman based his critique of “corporate social responsibility” upon the principal-agent problem. In the modern corporation, the owners of a firm are rarely its managers. Rather, the owners employ non-owning managers whose job it is to run the firm as successfully as possible. In general this means (to Friedman) maximizing profit. Only by doing this will the manager of a company deliver the promised value to the firm’s owners. As Friedman puts it, the manager “has direct re­sponsibility to his employers. That responsi­bility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while con­forming to the basic rules of the society…”

If a company’s management was actively pursuing “social responsibility” in a serious manner (i.e. not solely as a PR exercise), then they were effectively using the business’s money (and therefore the owners’ money) to solve social problems. Assuming that this social activity contributed little or nothing to the company’s bottom line, to Friedman this constituted a willful misuse of company money. In his eyes, managers were using their positions as agents of the principal (owners) to levy a form of tax on their corporation, and then using the proceeds from said tax to solve broad social problems. To Friedman, this was ridiculous. Corporations shouldn’t need to tax themselves to solve social problems; that’s what the government was for. If the popularly-elected government didn’t see fit to target a given problem, then what right did private companies have to tax their own owners to do the same?

To Friedman the only way to guarantee an equitable and free society was to have business focus narrowly on meeting the desires of its owners, leaving the business of social improvement to the government. In this manner, owners could trust that their funds were being used to the ends for which they were intended, and any social value created was incidental and not at the expense of the corporation’s owners. In this system, the only role of business, its true “social responsibility,” is to increase its own profit — and therefore the profit accrued to its owners and managers.

Friedman’s analysis is sound, and theoretically it makes a great deal of sense. His conclusion rests upon an assumption that CSR always has a negative impact on the bottom line; this may or may not be true, but will have to be discussed in future posts. The focus here is on his conclusion. If a firm cannot target social good without defrauding its owners, then should its only goal be profit?

This is certainly the simplest reasoning possible, and therein lies the problem. Targeting profit alone necessarily creates a relentless focus on short-term targets in the belief that constantly maximizing profits right now will lead to maximizing profits down the road. This is most clearly demonstrated by the Wall Street “earnings treadmill,” in which a firm’s overriding goal is to meet their quarterly earnings targets. Meeting earnings targets is rewarded by a bump in the share price; missing targets is punished.

This system reflects the practical but problematic application of Friedman’s idea that the social responsibility of business is to increase its profit. This application has created a rather twisted interpretation of a manager’s fiduciary duty to a firm’s owners. If a manager’s responsibility (and legal obligation as an employee) is to act in the best interests of the firm and its owners, and that interest is interpreted as “maximizing profit,” then any action that delays or defers profit can be viewed as a breach of fiduciary duty. A firm’s owners may then legally remove and replace the offending manager.

In this situation, it is entirely rational for the manager to maximize profit now, instead of deferring some profit that may mean greater profit later. To do otherwise would be to breach his fiduciary duty and risk the loss of his job. However, what is rational for the individual manager may not lead to rational choices for the firm as a whole.

Over the last several decades, the assumption that profit now equals profit later has been proven to be false time and again. The Northeastern cod fishing fleet largely destroyed itself (with a strong helping hand from backwards regulation) by harvesting its stock far too quickly. Bear Stearns went from being one of the most successful banks on Wall Street to effectively bankrupt in less than 12 months, largely by relying on short-term financing and aggressive pursuit of quick wins.

In each of these cases, decisions to maximize profit now led to an eventual long-term disaster. With this in mind, taking as given that a business’s managers are responsible to the business owners, the social responsibility of the firm should not be to maximize profit; rather, it should be to maximize the long-term value created for its owners.

These two ideas are closely linked but fundamentally different. Maximizing profit means viewing every decision through the lens of “what makes the most money right now?” Maximizing value means viewing decisions through the lens of “what will allow us to make the most money both today and tomorrow?” This will necessarily entail some tradeoffs between profit now and profit tomorrow. It may be the case that, by deferring profit now, more profit may be realized in the future. More importantly, such a tradeoff may prove necessary to preserve a firm’s capacity to continue to make profits into the future. Under the profits-first approach, however, any manager who attempts to defer profits now to ensure profits later is likely to be replaced by firm owners, particularly public corporations whose shareholders may simply sell their stake at any decline in profits.

In many ways, Friedman was right — corporations that undertake social activities outside their core interests may be harming their (and their investors’) bottom line. However, his overly-simplified view of corporate activities led him to make erroneous assumptions. A narrow focus on profit over value may lead to short-term decision making that makes money now, but ruins the company down the road. Therefore, the social responsibility of business should not be simply to make money, but to create long-term value for its owners. Such an approach may go a long way towards creating a more sustainable and socially responsible economy, but only if investors and owners insist on a shift in focus.