Business profit versus business purpose

September 18, 2012 | By | 2 Comments

Milton Friedman (Image source: Wikipedia)

If we want a sustainable economy we first need to take a closer look at the purpose of business.

In 1970, Nobel prize-winning economist Milton Friedman published a famous article The social responsibility of business is to increase its profits in the New York Times Magazine. For decades, the article served as the dogmatic backbone to legitimize a narrow concept of the purpose of business: “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game”. He goes on to explain that in a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business with direct responsibility to his employers.

That responsibility involves conducting business in accordance with the owner’s desires, which generally consists of making as much money as possible while conforming to the basic rules of the society. If a corporate executive announces social responsibilities as a businessperson the statement can either be treated as a) meaningless rhetoric or b) a negative proposal that threatens the interests of the employees. According to Friedman, if owners wish to perform an act of social responsibility they should do so on their own and not at the expense of employees.

This message is reinforced by the shareholder value concept, originally developed by Alfred Rappaport. Taking Friedman’s belief that management should first and foremost consider the interest of shareholders in their decisions, he developed a method to evaluate the shareholder value of different strategic decisions based on the estimation of future cash flow streams. Rappaport’s method has become very popular and is widely used (or abused) by companies and business analysts alike. Although the pursuit of short-term profit maximization was not his intention , the shareholder value concept became synonymous with short-term value maximization in the shareholders’ and managers’ own interests. In the context of “quarterly capitalism” and the extensive use of stock options to align the interests of managers and shareholders, Friedman’s message became identified as the doctrine of “greed is good”.

The Friedmanian doctrine – coupled with the shareholder value concept and stock option plans – has proven to be a powerful argument in favor of legitimizing ever-increasing profits and private income of shareholders and managers alike. Other interpretations were decried by Friedman as being socialist and ineffective. Yet, the fundamental questions remain: why should business be directly responsible only to the owners or shareholders? Why not to employees, customers or society in general, as many others have suggested? What gives owners such crucial importance for business? And just who are the owners in times of dispersed investor capitalism?

As capitalism evolved from entrepreneurial capitalism to managerial capitalism and into the current form of investor capitalism, ownership has been replaced by investment. Until the Second World War, owners effectively were identical to managers, a situation still found in many family businesses today, with no differences in interest between these two groups. Businesses were managed according to the long-term interests of the owners and their families. Responsibility was direct and personal, with the owner-manager often playing an important role in their communities. A key issue concerns the separation of the rights of ownership (or profit) from the responsibilities of ownership across the global economic system through the universal adoption of a system of limited liability, which commenced at the end of the nineteenth century.

With the rise of employed managers, a new class of professional administrators took over the management function in business, pushing entrepreneurial capitalism into managerial capitalism. This development was first analyzed by Berle and Means in 1932 in a study that focused on how legal ownership became separated from effective corporate control in the United States.

During the 1970s and 1980s we witnessed the arrival of investor capitalism. Since then, institutional investors adopted the role of owners, mostly managing their holdings for short-term profit, while ‘real’ owners were downgraded to the status of financial investors. Ownership in times of investor capitalism has lost its former clout, defined by long-term perspectives and responsibility of risk.

Given how ‘real’ ownership is being replaced by investment, it may be more accurate to treat most current shareholders as investors. Given that the average holding period for U.S. equities has decreased from 7 years in the 1970s to 7 months today, we may even want to call them speculators. Worse still, “hyper speed” traders – some of whom hold stocks for only a few seconds – now account for 70 percent of all U.S. equities trading.

Although the somewhat situation may be different in other parts of the world, the trend towards short-termism is spreading globally. Quite simply, investors are mostly involved for higher returns in favour of pride and sense of responsibility which owners used to have. If investors are not satisfied with the returns or find a more promising investment, they give up their ownership without a second thought. Businesses are under increasing pressure to meet investors’ expectations, in order to maintain their share price and ensure access to new capital.

Peter Drucker (Image source: Wikipedia)

Other business concepts have been explored in the past. Peter Drucker, who has been called the man who invented the concept of management, developed a broader concept of the purpose of business. For Drucker, profits may be the result of management but they are not its purpose. Profit is the price a business has to pay to the owners to stay in business but profit should not serve as a guiding principle of business management. For Drucker, the purpose of business lies within society – given that business is an element of society, just like any other institution.

 

Drucker defined the dimensions of management as economic performance, making work productive and the workers successful, and considering the impact on society. Every social institution exists for a specific purpose. In the case of the business enterprise the specific purpose is economic performance, which is intimately tied to supplying goods and services to customers in an economical way. The second task of management is to make work productive and the worker successful. As business has only one true resource – people – management performs by making human resources productive. Drucker’s third dimension is managing the social impacts and the social responsibilities of business. He specifies: “None of our institutions exists by itself and as end in itself. Everyone is an organ of society and exists for the sake of society. “Free enterprise” cannot be justified as being good for business. It can be justified only as being good for society.” In comparing these three dimensions Drucker makes it clear that it is impossible to separate these functions, each of which has a primacy of its own. Managing these dimensions has to be done at the same time and within the same managerial action.

In the meantime,  the business of business largely concerns short-term profit – but we beginning to realise that it is no longer enough.

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Comments (2)

  1. The paradigm shift from entrepreneurial to managerial to investor capitalism carries with it changed, and societally destructive, rules of engagement.

    The first shift is in the approach to risk. Entrepreneurial cultures work with risk because they have to do so. Managerial cultures try to manage risk as a part of the organization. The investment culture, however, looks to exclude risk. What this means for the investor business paradigm is that business elements posing risks, such as employees, customers with low profit margins, etc., should be excluded from the scope of service of the business. Although an individual business may be able to do this for a while, society cannot do this without social unrest.

    The second shift involves the overtaking of decisional rules based on complex social system factors, many of which cannot be quantified, to a mathematical model. Investors are driven somewhat by social influences but do rely heavily on quantitative approaches to decision making. Such models fail to capture the complexity of social systems and often lead to exaggeration to the point of societal destruction.

  2. E Mebratu

    Further to D Gilbert’s post: in other words, include irrational elements in your decision-making process as a leader/manager/entrepreneur. Be driven not only by what is right, but also by what feels right.
    What about including this aspect in business school curriculum ? And I think this goes beyond the now-spreading ‘personal evelopment’ activities, but rather refer to acknowledging and valuing each person’s spiritual and intuitive capacities. As far as I know, we are still far away from these practices.

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