Why Profit Maximization Can Be a Losing Strategy

Last updated: Apr 02, 2012

Here I will assert that profit maximization is not only a morally repugnant approach, but an ineffective strategy for businesses hoping to survive for a long span of time in the modern era.

I will take a utilitarian approach to criticize Freidmanian profit maximization and present more effective ways to sensitize players in business field to social and environmental issues than ethical critique alone can do. I think ethical claim does not sufficiently appeal to people and mobilize people into action due to Machiavellism. Although a number of companies now are taking corporate social responsibility seriously, they seem driven more by an empirical realization of business risks and opportunities than an ethical epiphany. Therefore it is important to shed a light on why Freidmanian profit maximization could put business growth and sustainability in jeopardy and what benefits they can get if they choose to take a different approach. Thus I would not go into much detail on ethical accusation of the profit maximization, although I will not entirely exclude.

Before I proceed, I would like to define some of the keywords that will be frequently used in this article, for better understanding. I will define value as blended value[1], coined by Jed Emerson, which refers to non-divisible blend of three elements- environmental, social, and economic impacts created by business activities. Next I will define responsibility as a duty that binds people to a certain course of actions, made legitimate by their action. The “action” part is crucial as we can use it to justify holding people legally accountable. Lastly I feel I need to define perhaps the most evasive concept, Freidmanianian profit maximization. I will interpret profit maximization as referring to any corporate behavior to maximize financial benefits for the existing stockholders, the scope of which does not necessarily include potential stockholders who might buy the stocks in the future or people related to the business in general such as employees, community, and suppliers who do not hold any stocks at the moment.

Simply put, I think there are three major reasons why businesses should not take a Freidmanian approach. First the approach seems unable to satisfactorily serve its fundamental purpose in the long run; excellence in financial performance. In addition, Friedmanian approach allows businesses to take responsibility for only the fraction of the impacts on the physical world, caused by their business activities. Lastly, the approach is not morally defensible by any ethical theories, as shown in Ivar Kolstad’s the article.

Overemphasis on profits easily makes business people short-term thinkers, setting up a huge obstacle for the continuity of businesses. That is to say, profit maximization with conditions conducive to short-sightedness poses a significant threat to long-term profitability of business. This may sound contradictory, but dozens of business cases show that if a business take Freidmanian approach to an extreme, the business is likely to fail to achieve best financial outcome in a long term perspective, due to short-sightedness.

To discuss short-sightedness further, we need to start from the background of Milton Friedman who strongly supported the idea of profit maximization. Milton Friedman was an economist, after all, who has long championed Neo-classical economics. Thus his worldview was deeply tangled with the unrealistic assumptions of Neoclassical economics; infinite far-sightedness, perfect rationality and infinite selfishness. These assumptions are so naively idealistic and dangerous that a number of people in academia have been severely critical of them. The biggest problem lies in the fact that they tried to apply these assumptions to real world. The Neoclassical economists were brave enough to assume far-sightedness and rationality in real human-being for their models.

Apparently people do not just behave that way and they are not as far-sighted and rational as they expected and hoped. We did not evolve to be good long-term thinkers. We are full of what economists call time inconsistent preferences and not good at keeping ourselves from taking an immediate benefit for the bigger reward in the future. Take a simple daily problem for example. It is very difficult not to munch a deliciously-looking chocolate cake at hand. The chocolate cake is a metaphor for profits. It’s not easy to give up on visible and immediate profits for the less overt-mostly bigger-profits in the future.  This is especially true when the company is under huge pressure to meet the existing shareholders’ needs. Executives for public companies are tempted to do whatever it takes to make their financial report look good, and some companies like Enron and WorldCom actually did. Infatuation with profits easily leads to excessively high pressure for performance in short term, usually within a time frame of one to ten years. This unusually high pressure makes highest ranking managers of the company short-sighted and inhibits long-term thinking. Thus these conditions put a realistic limitation on thinking and behaving in a long-term perspective and when immediate benefits are overt, they would trick executives into grabbing it. When the temptation peaks, we need some devices to help us put a stop on our stupidity; ethics.

Secondly, Freidmanianism allows corporations not to take full responsibility for the consequences of their operating activities, as it is rooted in Neo-classical economics. If we follow the definition of responsibility that I mentioned earlier, companies should be responsible for larger costs than they and we usually assume. They are the culprits-we all are without exceptions- who created footprints on the physical world with their series of actions. Claiming for responsibility holds valid in this sense, even without any moral consideration. The actions taken by businesses will have some impact and therefore we have a good reason to hold businesses accountable for the impact caused by their own actions. According to Amory Lovins and Paul Hawken, in their book “Natural Capitalism”, they say that the impact is too much underestimated. Paul Hawken argued “Markets are superb at setting prices, but incapable of recognizing costs.” By costs he meant here the true costs[2] that include almost unforeseeable impacts on the environment and society, like the Butterfly Effect. Therefore there is a corporate responsibility. It is not a philanthropic request, but a fair and valid claim for citizenship. Historically the costs they paid, calculated by the legal guidelines, have never been enough to offset the negative impacts they created, which means companies are not holding full liability for what they have caused.

To better understand this issue, we need to take a look at Neo-classical economics again and find a logical hole in Friedmanian approach. They say in order to process profit maximization, we need all information available and we only move for our own self-interests. With these far-fetched assumptions, economists would do what Paul Hawken, famous environmentalist, calls “optimization in isolation”. By isolation I mean there are variables that were not taken into account, as they are unknown or deemed ignorable. In other words, in order to proceed with maximization or optimization calculation, one had to draw a certain boundary and process with variables only within that circle. What’s worse, for the simplicity and predictability’s sake, one had to disregard anything unknown or not easily measurable as ignorable factors such as environmental or social cost incurred by businesses. Thanks to this reasoning, irresponsible businesses could survive. Although the factors are intrinsically difficult to measure, it is not impossible, much less ignorable. If we had incorporated what Paul Hawken calls the true costs in cost structure of companies, they would never have turned profitable as they did without some significant change in strategy.

Finally, profit maximization lacks firm moral grounds. The article “Why Firms Should Not Always Maximize Profits” lists four major critiques for CSR and presents counter-opinions for each. Although I feel no need to repeat them here, I would like to mention one aspect of ethical critique. We need to rethink the concept of ownership of a business. I think it is not fair to say that shareholders are the only and true owners of a company. According to Jeremy Rifkin in his book “the age of access”, American economist, the notion of ownership that contemporary ones are used to was initially developed by John Locke in 17th century.[3] John Locke claimed “each man creates his own property by adding his labor to the raw stuff of nature, transforming it into things of value”. If we follow the rationale that Locke provided as above, the main owners of company should be employees who made greatest contribution to the value-creation process. At least they should be treated as equivalently as shareholders who gave capital. Therefore one cannot justify the traditional favoritism on shareholders. Of course this logic fails to include various parties as suppliers, customers, and other interest groups. Yet this is enough to show how much unstable logical ground Friedmanian argument is standing on, in terms of ownership.

Having said of three reasons why businesses should not follow Freidman’s approach, there are good reasons why many businesses still do not seem to really deviate from profit maximization. One reason might be a sense of fairness. With governments not fully addressing social and environmental issues-lack of monitoring and strong enforcement against corruption and environment-destructive behaviors- it might be a tall order for businesses to change. As the article “Why Firms Should Not Always Maximize Profits” shows, there is a real dilemma-CSR and profits do not always go together. CSR will often push up the cost and this might put businesses at competitive disadvantage against those who do not. Another reason may be the psychological reason. Psychologist Tim Wildschut argues in the article “A Paradox of Individual and Group Morality” that individuals behave differently when they are in a group, compared to when they remain as an independent individual. This suggests a group of individuals might make an unethical choice, even if the individuals are moral and ethical. I think there will be a few more reasons that can explain inertia of business world.

Nevertheless, there is a way out. Renouncement of Friedmanian profits can be a huge opportunity for businesses. As I said, lack of careful attention to social and environmental issues will lead to poor reputation or in worst case scenario collectivistic boycott for companies’ products, given the current business settings where people are increasingly aware of social and environmental issues and expect sincere attention to those issues from business side. Yet at the flip side of this business risk is a solid business opportunity. This can be done in practice by CSV (Creating Shared Value)[4], coined by Michael Porter, a professor of Harvard business school. He asserted that “the concept of shared value can be defined as policies and operating practices that enhance the competitiveness of a company while simultaneously advancing the economic and social conditions in the communities in which it operates”. In other words, businesses should consider societal and environmental issues as a business opportunity to strengthen their core competency. In this sense, CSV breaks the mutual exclusivity between economics and social benefits that we have assumed.

According to him, CSV also works in practice, regardless of the size. A good example for big company can be found at Nespresso from Nestle, which had enjoyed annual growth of 30% since 2000. Nestle identified in the coffee business the problem that most coffees are grown by small farmers in poor rural regions. The company gave advice on farming practices and guaranteed bank loans. Also they set local facilities to measure the quality of coffee to pay premium for those who grew better coffee, which in turn became an incentive to improve the quality. As a result, Nestle came to have coffees of better quality which led to better sales and suppliers of coffees also benefited from a series of helping programs in addition to financial rewards. Nestle effectively used a societal problem as a business opportunity to reinforce their competitiveness.

This does not apply only to established companies. There is one start-up, which now has grown much, that succeed to show to world that CSV is possible in practice. The name of the company is RecycleBank, founded in 2004 by Patrick K. FitzGerald and Ron Gonen. What it does is to provide points to its members to reward environmentally-friendly behaviors as recycling their household garbage, using energy more efficiently at home, reducing water usage, buying greener products and so on. While haulers and waste processors take the recycled garbage, Recyclebank takes as a fee from municipality they partnered with. Recyclebank has been ranked as 37th as one of the World’s 50 Most Innovative Companies in 2012, by Fast Company. They discovered the problem that people are not motivated enough to do environment-friendly things and build good business model on it.

Moreover there is good news for businesses which are concerned about cost pressure. Awareness of general public, especially in developed nations, to the social and environmental issues is rapidly growing. Third-party entity that monitors the CSR performance of businesses is growing in number and scope. People seem to be willing to pay premium for goods associated with social and environmental meaning, if not always. Also this means people now punish those who do not go with the responsible flow. As Ivar Kolstad said, it is our duty as a citizen to reward companies pursuing beyond profits.

To sum up, it is not only ethical to maximize only the shareholders’ value, but also not smart to proceed with blind pursuit of profits as a sole objective for corporations, because it would lead to poor financial performance in the long run, due to short-sightedness. Also if true costs are incorporated, businesses that do not take CSR seriously will not be able to survive. It is not fair, however, to claim that pursuit of profits is intrinsically bad. As Peter Drucker said, “Profitability is a sovereign criterion of an enterprise”. I understand deviation from profit maximization might project a bleak outlook for business people who still hold conventional point of view, but there is a silver lining. If businesses identify social and environmental challenge as an opportunity and find alignment between corporate financial goal, and society-and-environment-related goal, they could achieve what Friedman truly wanted to achieve; rich profits. As I stressed in the introduction, it is also important for us to make an ethical criticism against the Friedmanian profit maximization in parallel. Yet in this era where Machiavellism prevails, criticism from businesds perspective might be more effective argument that can bring change in practice.

[1] Jed Emerson, The blended Value Glossary, 2004, http://blendedvalue.org/media/pdf-blendedvalue-glossary.pdf

[2] Paul Hawken, The Ecology of Commerce: A Declaration of Sustainability, HarperBusiness(1994)

[3] Jeremy Rifkin, The Age of Access, Tarcher(2001)

[4] Michael E. Porter and Mark R. Kramer, “Creating Shared Value: How to reinvent capitalism”, Harvard Business Review(January-February 2011), 10

comments powered by Disqus