Michael Byers
At the height of his fame, Mark Twain was approached by an editor who was assembling a litany of insights into what he would eventually title On the Art of Writing. Never at a loss for a quip or some cornpone counsel, the author of Life on the Mississippi and The Adventures of Tom Sawyer was happy to share a few pointers. Among other gems, he emphasized word choice as a capital element of accomplished writing. “The difference between the almost-right word & the right word is really a large matter,” Twain contended. “It’s the difference between the lightning-bug & the lightning.”
I have been thinking a lot about this declaration recently, for whenever my students turn their sights to questions of shareholder primacy, the responsibilities of management, and the mission of the modern company, they seem to get tripped up by the very words they’re using. They have strong feelings about the role corporations might play in supporting equity, curbing climate change, and improving society generally, but they struggle to square these impulses with what they have long heard is the incontrovertible purpose of a public company: to maximize profits.
Whatever the wisdom of this commitment, as a legal matter it’s simply not required, so I’ve encouraged them to ponder a different question: Rather than maximizing profits, what’s so wrong about a company being merely profitable instead?
The distinction between maximizing profits and being merely profitable might seem small, but much like the lightning bug and the lightning, the difference between them has loomed large in the minds of many economists over the past 50 years. Take one of the most famous among them, Milton Friedman, who warned in 1970 that business executives who “declaim that business is not concerned ‘merely’ with profit but also with promoting desirable ‘social’ ends” were effectively “preaching pure and unadulterated socialism.”
The allegation appeared at the start of “The Social Responsibility of Business Is to Increase Its Profits,” Friedman’s legendary essay in The New York Times Magazine. Now regarded as the opening salvo in the shareholder-value revolution, the essay can sometimes read like a slightly eccentric screed against creeping socialism in corporate America, but Friedman anchored his argument in a concern about public companies that goes all the way back to the 18th century and the writings of Adam Smith.
Companies, of course, can offer any number of desired things—a fancy title, the corner office, extended maternity leave—but when it comes to crowding out an interest in other goods, money proves uniquely effective.
While Smith wrote about business affairs nearly a century before the full force of the Industrial Revolution made common the kind of capital accumulation that railroads, steel refineries, and other heavy industries required, his study of trading ventures such as the East India Company left him skeptical of what he called the “joint stock company.” The reason was simple. As he observed in The Wealth of Nations, those who ran such enterprises, “being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.”
Smith was describing a dilemma of organizational management that would come to be known as the principal-agent problem. In simple terms, say I am a business owner, or a principal, and I employ you to make money for me as my agent. Because I, not you, enjoy the benefits of your labors, you are unlikely to be as scrupulous and diligent with the capital I give you as I would be were I managing it myself.
Such a misalignment of interests—I want you to work as hard as possible; you want a three martini lunch—can be a problem for most any employment contract that relies on strict wages or a salary. However, in his New York Times essay, Friedman portrayed it as a special concern for the modern company, where shareholders who own a business and the executives they employ are mostly invisible to one another. “The whole justification for permitting the corporate executive to be selected by the stockholders is that the executive is an agent serving the interests of his principal,” Friedman wrote. The agent “has direct responsibility to his employers,” he declared, “to conduct the business in accordance with their desires, which generally will be to make as much money as possible.”
But saying as much merely restates the principal-agent problem, which is essentially what Friedman did, at length, in his essay. What he didn’t provide is a remedy.
If corporate executives fail to act “in accordance” with the “desires” of their shareholders, how do you go about reforming them? This was a chief concern of another celebrated economist, Michael C. Jensen, who along with William H. Meckling pursued this problem across nearly two decades of scholarship.
The work of the two men began with a landmark 1976 paper, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” As the ambitious scope of its title suggests, the paper, which provided a structural analysis of a corporate enterprise, aimed at once to be fundamental in its focus and groundbreaking in its conclusions. It accomplished both tasks by the way it radically simplified the essence of a company. As Jensen and Meckling asserted in the opening pages of the article, “It is important to recognize that most organizations are simply legal fictions which serve as a nexus for a set of contracting relationships among individuals.”
If the language had the awkward formality of a seminar paper, the claims were mostly unremarkable at first glance. Yes, organizations are typically structured by a series of laws involving their incorporation and conduct, and, yes, the behavior and relationships of those who work for them are shaped by their employment contracts.
But look again at the sentence—is it really true that such “legal fictions” are “simply” all that a company is?
A year of crises has heightened the debate about what corporations owe society.
Is the Friedman Doctrine Still Relevant in the 21st Century?Jensen and Meckling thought so, and, importantly, that assumption served to limit the potential remedies one might apply to the principal-agent problem. Rather than trouble oneself with handsome abstractions involving the mission of an organization or the values of executives, one could focus instead on how a company should structure its employment contracts to ensure that they embody the interests of shareholders to make (in Friedman’s words) “as much money as possible.”
How do you go about doing so? The answer for the two economists was to focus on creating employment contracts that have the power to better align the behavior of corporate executives with the profit-maximizing interest of shareholders. What might such behavior look like? Consider how Jensen and Meckling described the “operating decisions” that someone who owns his own company would make to “maximize his utility”:
These decisions will involve not only the benefits he derives from pecuniary returns but also the utility generated by various non-pecuniary aspects of his entrepreneurial activities such as the physical appointments of the office, the attractiveness of the office staff, the level of employee discipline, the kind and amount of charitable contributions, personal relations (“love”, “respect”, etc.) with employees, a larger than optimal computer to play with, purchase of production inputs from friends, etc.
Another way of putting this is that those who run their own companies act like pretty normal people. The way they spend their time reflects the fact that they care about many things: leisure, friendship, civic commitments, health, family, aesthetics, social esteem, and, yes, money too.
Jensen and Meckling understood this. Nearly 20 years after “Theory of the Firm,” the duo published another boldly titled paper, “The Nature of Man.” In it, they dismissed what they termed the “economic model” of human behavior, a model that assumes individuals do “not care for others, art, morality, love, respect, honesty”—nothing except money. (“People do not behave this way,” they tersely note.)
In place of the economic model, Jensen and Meckling proposed what they called the “resourceful, evaluative, maximizing model” of human behavior, or REMM. REMM assumes that human beings care about all sorts of things: “knowledge, independence, the plight of others, the environment, honor,” and so forth. Accordingly, people are “always willing to make trade-offs and substitutions” under this model to “enjoy the highest level of value” across everything they desire. They are not working feverishly to maximize the amount of money they have—money is only one good; they are trying to maximize their aggregate utility across all of the goods they covet.
Whatever you make of this model, if you take it seriously, it soon becomes clear how Jensen and Meckling (and their acolytes) proposed to overcome the principal-agent problem in the case of executives at a publicly owned company. The goal can’t be to make the agent of a company act as the shareholding principal would if the principal were in the agent’s position. If we assume that the principal is a relatively normal person, they would never spend their days maximizing profit, regardless of how much of the company they owned. (Again, “People do not behave this way.”)
No, rather than working to match the behavior of the two parties, you must make the agent act in a way the principal would not act, the way no normal person would under everyday circumstances. You must ensure that all an agent thinks about is maximizing profit. And how do you do so? By structuring employment contracts in such a way that an agent will be willing to set aside any concern for all other goods in favor of one good precisely: money.
The choice is not between enhancing the bottom line or going bankrupt. (If a company goes out of business, it can’t do any good at all.) Rather, it is a choice between maximizing profits or being merely profitable instead.
“Like it or not,” Jensen and Meckling stressed, “individuals are willing to sacrifice a little of almost anything we care to name, even reputation or morality, for a sufficiently large quantity of other desired things.” Companies, of course, can offer any number of desired things—a fancy title, the corner office, extended maternity leave—but when it comes to crowding out an interest in other goods, money proves uniquely effective. “The main advantage of money in this mosaic of organizational incentives is that general purchasing power is valued by almost everyone,” Jensen contended in another 1994 paper, this one in the Journal of Applied Corporate Finance. What’s more, he emphasized, “it can be varied easily with performance.”
In turn, for those like Jensen and Meckling who favor pay-for-performance incentive plans (bonuses, stock options, and the like) as a means of remedying the principal-agent problem, the goal is not to make the behavior of the agent conform to how the principal would behave were they in the agent’s position. That would be an exercise in empathy. The goal is to make the agent behave in a totally aberrant way by offering them so much of one single good (money) that they forget all others in pursuit of it.
Importantly, that goal is made easier by two further differences between a principal and the profit-maximizing agent in the risk calculus of their actions. While the sole proprietor or head of a family business is unlikely to hazard the ignominy and disdain associated with maximizing profits at the expense of any other social, moral, or civic concern, corporate agents are typically part of a byzantine hierarchy of middle managers. They make their decisions far away from prying eyes, without any imminent danger of moral embarrassment.
The financial risk faced by principals and agents is also radically different. Any work contract will only substantially shape the behavior of agents by promising upside. Yes, failure can result in the loss of a job, but not in personal bankruptcy. That’s a possibility an owner-operating principal must always keep in mind when making decisions. Corporate agents, on the other hand, are always playing with house money. They can far better afford to be extravagant, even reckless, in the bets that they take.
Why might someone think it’s a good idea to organizationally engineer a company so that the overwhelming concern is maximizing profits if doing so tends to dramatically warp employees’ behavior?
When you read those such as Friedman, Jensen, and Meckling who helped to usher in the shareholder-value revolution, three reasons become clear. First, there seems to be a belief that by maximizing the profit of a company, you maximize any utility it might otherwise provide society. (If, organizationally speaking, the company cared about more than one good, the consequence would always be less beneficial for society.) Second, by focusing the endeavors of corporate executives on one aim and one aim only, you bring greater clarity to strategic planning, real-time decision-making, and the deployment of scarce resources. Finally, and most strikingly, there seems to be a kind of philosophical contempt for the idea that corporate executives should actively champion anything beyond maximizing profits, especially those goals that fall under the umbrella of corporate social responsibility. “Businessmen who talk this way,” Friedman said in his New York Times essay, “are unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades.”
Such antipathy helps to explain why Friedman was sounding his alarm at a time when the US economy was the envy of the world. Consider that between 1945 and 1975, US GDP grew more than sevenfold, from $228 billion to $1.7 trillion. Yes, the rest of the world was beginning to catch up, and certain sectors of the economy, such as the automotive industry, were starting to show signs of decay, but if the aim of Friedman and others was to radically rethink the mission, purpose, and place of a company in society, it wasn’t because American capitalism was obviously failing.
Yet even if theirs was a solution in search of a problem, those who fired the first shots in the shareholder-value revolution won a complete and thoroughgoing victory. Even today, I see it in my MBA students. Whatever else a company may do, they feel it in their bones: It must be consistent with maximizing profit. Companies can support sustainable growth, treat their employees well, and be good stewards of the community, but only if such actions enhance the bottom line. They can do good and do well, provided they couldn’t possibly be doing better.
Now, surely, sometimes these goals coincide—but what if they don’t, at least not so neatly? Then, as an executive, you must choose, and the choice is not between enhancing the bottom line or going bankrupt. (If a company goes out of business, it can’t do any good at all.) Rather, it is a choice between maximizing profits or being merely profitable instead. If you commit to the first goal, the social, moral, and civic goals that so many of my students truly care about can only be supported as a matter of unintended consequences and secondary effects. As an executive, you may get lucky, but if not, your hands are tied. By contrast, if you orient your work around being merely profitable, you accept the double burden of building a viable business while also ensuring some salutary impact on the world around you.
Like Twain’s warning about the lightning bug and the lightning, I suspect Friedman would say that the difference between maximizing profit and being merely profitable is really a large matter. On this point, there’s no doubt: The two of us are completely aligned.
John Paul Rollert is adjunct associate professor of behavioral science at Chicago Booth.
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