July 04, 2004

On Value Maximization and the Stakeholder Economy

(Letter to The Economist)

SIR-Professor Jensen’s article “whose firm is it anyway?” attacks in a rather simplistic way the stakeholder theory as incompatible with capitalism. According to him, value maximisation ought to be the firm’s sole objective. Acting in this way, the firm maximises also social welfare and contributes to an optimal allocation of scarce resources in the economy. These views are of course by no means new. They are deeply rooted in monetarism and supply-side economics and it could suffice to quote here their principal advocate, Milton Friedman, writing that “…few trends could so thoroughly undermine the very foundation of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as possible…” Over the years, these views have been harshly extrapolated. Thus, there is nothing wrong with the corporation that does business with corrupt foreign governments and undemocratic regimes; that completely disregards the environment, industrial relations, the funding of research and universities, better health care, religious observances, arts and culture. The corporation is in it just to maximise profits and all else is a chimera, as Professor Jensen puts it.

Often in possession of considerable market power, however, the large corporation -fulcrum of the western industrial system- does not have to maximise returns any more than its executives’ performance have to relate to their, sometimes exorbitant, salaries. To suggest the opposite, i.e. that executives put forth less than their best effort for their present income after taxes, would be a gross insult to most of them. With the separation of ownership from management, what William Baumol called the “security of the management team” has a big role to play here: profit maximisation entails the taking of additional risks that may threaten the “survival” of the management team. The latter would thus opt for loss minimisation rather than maximum return. As R.A. Gordon has so succinctly put it “…executives of large corporations do not receive the profits which may result from taking a chance, while their position in the firm may be jeopardised in the event of serious loss…”.

Professor Simon[1] has offered yet another persuasive hypothesis about the objectives of firms. He has argued that in many cases management recognises implicitly or explicitly the complexity of the calculations and the imperfections of the data which must be employed in any optimality calculation. As a result, firms frequently give up the attempt to maximise anything -profits or sales or anything else. Instead, they set up for themselves some minimal standards of achievement which they hope will ensure the firm’s viability and an acceptable level of profit. Firms which are satisfied to achieve such limited objectives are said to “satisfice” instead of maximising. Starting from this hypothesis, a number of investigators led by Cyert and March[2] have attempted to develop what they call a behavioural theory of the firm -one which seeks to show how firms really act, not just how they ought to act if their decisions were all optimal. Using computers to simulate observed decision processes of a number of companies, they have achieved remarkable success in employing some of these programs to predict company decisions. Though one may question whether they have provided a theory or an empirical approach and evidence for the construction of a theory, the significance of the entire analysis is undeniable. Certainly we can no longer operate comfortably on the assumption that profit maximisation adequately explains all of the observed business behaviour.

Profit maximisation may indeed be the survival kit of the ice-cream store around the corner, but clearly it cannot be the prime goal of the mature corporation that transcends markets, manages demand and relies on the government underwriting of expensive technology. In addition, the need for long-term planning in product development does not allow the corporation to fall victim of fluctuating prices and unstable demand. Instead its primary goals are to achieve a “secure” level of earnings, maintain price stability (often through collusion), manage demand and of course grow, i.e. increase its market share. The Dutch electronics giant Philips controls 70% of the Brazilian market for consumer electronics but, as many Philips executives will no doubt attest, the reasons for pursuing this strategy have very little, if anything, to do with profit maximisation. Discounting the prominence of profit maximisation, achievement of the above primary objectives allows easily the pursuit of other lesser ones that fall into the sphere of “social responsibility”. A company that acts in what many would describe as a socially responsible manner is fully compatible with capitalism and consumer sovereignty: apart from promoting a sound corporate image, it capitalises on increased consumer awareness on societal concerns and by doing so it also takes care very nicely of its own bottom line. Consumer reigns again.

As far as optimum resource allocation is concerned, the argument has been important in the past and in the less developed societies of today where choice among pressing physical needs is still pertinent. In mature and affluent economies, however, the choice is not between bread or housing but between psychological and well-cultivated wants, ranging from intelligent tooth brushes to cosmetic surgery. To quote Galbraith “…if this choice becomes increasingly less important with rising incomes, the economic problem also diminishes in importance and so do, more poignantly, the scholars who dwell on it…”

Hercules E. Haralambides
Professor of Economics
Erasmus University Rotterdam

[1] Herbert A. Simon, “Theories of Decision Making in Economics”, American Economic Review, Vol. XLIX, June 1959; and also, “ Models of Man”, John Wiley and Sons, Inc., New York, 1957.
[2] R.M. Cyert and J.G. March, “A Behavioral Theory of the Firm”, Prentice-Hall, Inc., Englewood Cliffs, N.J. 1963.