Saturday, August 11, 2012

Maximize the Likelihood of Being Profitable, Not Profits

I hope Joe Nocera is right in today’s New York Times when he says that the wheel is turning, and the primacy of shareholder value is beginning to return to the muck from whence it came.  He is right to say, however, that any alternative framework that aims to take its place must be capable of being distilled into a simple, compelling insight.  Here I modestly offer my own candidate: firms should maximize the likelihood of being profitable, not profits.  In this way they will be viable, lasting instruments for the wider purposes they ought to serve.

To see why this would make sense, first consider the case for profit maximization.  This rests on the assumption that the costs and revenues of the firm are perfect representations of the value to society of the resources it gobbles up and the goods and services it produces.  If this were true, profit would be the financial reflection of its net contribution to our well-being.  And if financial markets price shares according to the best possible forecast of future profitability (another big if), net value creation would align pleasingly with shareholder value.

But costs and revenues to the firm do not magically reflect social burdens and benefits, for a large number of reasons, among which should be included:
  • the vast number of uncompensated externalities, many but not all environmental, that drive an immense wedge between private and social costs and benefits;
  • the potential for transfers from workers, suppliers, consumers and communities to inflate profits despite zero or even negative net social benefit;
  • the inability of market prices to capture intrinsically nontradable values—ethics, human rights, democracy.
In an imaginary world one could visualize a perfect multidimensional regulation of firms that took care of all these concerns, so that profitability could be restored as a valid indicator of social benefit.  In the real world that is quite impossible (in part because firms that profit from a failure to regulate use their earnings to keep it that way), and the blind incentive of profit maximization causes widespread harm that offsets its benefits.

The alternative is a system of stakeholder primacy.  Governance of firms should reflect the full constellation of interests that firms ought to serve: workers (through labor law reform) should have a strong voice, as should the relevant professions, and also the affected public through a variety of governmental and nongovernmental organizations.  (This sentence takes the place of a much longer discussion, which would be difficult to summarize in a blog post.)  On top of this, it is essential to build a culture of collective responsibility among managers—another topic for deeper rumination.

The logical financial imperative for a stakeholder regime is maximization of the likelihood of profit.  In the end, a firm either pays its way, including the cost of capital, or it must liquidate; solvency is the one eternal rule of any and all economic systems.  Either you make money or you lose it, so you have to make it.  To fulfill its economic and social objectives, regularly making a profit, year after year, is a firm’s existential mandate.

Note that maximizing the likelihood of profitability is not a static objective.  The firm’s technology, its markets and the strategies of its competitors are constantly in flux, and keeping its bottom line in the black requires flexibility, innovation and a willingness to take risks.  Over a very long period of time, with as the cumulative effects of economic changes are felt, most firms will reach the end of their natural lifespan: entry and exit are necessary features of a stakeholder system just as they are for a shareholder system.

For an economist, the interesting question is, analytically, what is the difference between maximizing profits and maximizing the likelihood of being profitable?  One obvious answer is that they lead to different approaches to risk.  Consider two business strategies.  One has a 10% chance of making $2B and a 90% chance of losing $100M; the other a 90% chance of making $100M and a 10% chance of losing $100M.  The expected value of the first is $110M, the expected value of the second $80M.  Profit likelihood maximization is conservative, risk-minimizing; it tells you to go for the second strategy.  In fact, this kind of exercise shows that there may be situations, like startups in volatile industries, in which the return to a small chance of success is so great that profit maximization is a good idea.  As a generalization, these situations would be ones in which the maintenance of organizational capital is not an important consideration relative to other goals.

Another difference may be important, however: these two approaches have radically different implications for the treatment of organizational assets, like the capacity of the workforce, goodwill in the community and the ability to innovate and react flexibly.  Profit maximization encourages cashing in on them in the near term; profit likelihood maximization leads to building them over a longer time horizon.  There is a large literature in management and the “varieties of capitalism” that documents this contrast as a core empirical finding.  Example: if the possibility exists, cutting wages and pensions is the first thing a private equity fund is likely to do after assuming ownership of a firm, even though it increases turnover, depletes firm-specific human capital and eliminates a potential financial buffer for future emergencies.  It is the last thing a stakeholder-oriented firm will do—but it is there in reserve for when it is really needed.

My guess is that it would not be difficult to demonstrate these properties formally.  It looks like a nifty journal article to me, and if I ever get the time I will play with it.  But publications don’t matter to me at all, and if you do it first—fine, be my guest.  But someone should put it out there.


JW Mason said...

This is a good and important argument. I'd be very glad to see argument for why firms can, should and in general do serve a wider range of objectives than profit maximization, made more widely.

One quibble: it's important to be clear that under the current regime what's being maximized is profit to the shareholders, not profit at the level of the firm. Limited liability means the present value of the firm has a lower bound of zero. So in your example the expected values are $200 million and $90 million. The conclusion is the same in that case, but in general maximization of shareholder value is the principle that dominates corporate governance rules and the theory of the firm. Not maximization of profits as such. In some cases that distinction is important.

jason.olasky said...

Not even profit to the shareholders, (short-term) profit to the control group.

greg said...

I see you disagree with Milton Friedman:
"there is one and only one social responsibility of business- to use it(s) resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud."

I do, too.

If a business' one and only social responsibility is to increase its profits, clearly staying within the rules of the game, ie acting socially responsible, is secondary.


Great piece for thought. If we continue to use "profits" as a guideline, it does not matter it is maximization of profits or likelihood of being profitable as long as profits are measured in the accounting sense, supported by most legislations. Until we change the definition of profits and make them "profits to society", by valuing costs and revenues, assests and liabilites closer to their values to society, we will continue to bias the firm's activities towards financial returns. The "new" accounting is light years away, but we must move in that direction to assure corporate and society's sustainability

Jack said...

If a corporation has the same Constitutional rights and protections as does the individual citizen, does the corporation have the same responsibilities to the state that affords it those rights and protections? Is there a "social responsibility" that goes along with those Constitutional rights and responsibilities? How can an entity which enjoys the same Constitutional status of an individual citizen have no responsibility to the state or the other citizens of that state?