Profit Maximization: A Much Abused Doctrine
By Anthony de Jasay
Business education tends to produce zombies with self-contradictory minds.
Except for medicine—which dates back to the 10th century in Salerno—early institutions of higher learning in Europe used to consist of philosophy, mathematics, history, and the classics of literature, whose purpose was not the direct application of these disciplines for practical purposes. Such professions as the law, soldiering, and seamanship as well as architecture and the various branches of engineering had been learned in apprenticeships and through practice in the field. They began to have their place in the universities only in the last two centuries. After the Second World War, they were joined by business schools, which have rapidly taken a more and more prestigious place in graduate studies.
It is tempting to regard the very subject of management science as a confidence trick without any deliberate fraudulent intention, but nonetheless causing both professors and students of the discipline to gain prestige, goodwill, and careers by cultivating a subject which perhaps two generations ago would not be considered as a subject at all. Much of it is written in management consulting English or what we might also recognise as “junior vice president-ese”. In fairness, it must contain useful knowledge as well as the practice of thinking about the application of the subject to real life situations, because otherwise the subject would not have become quite as popular as it has. Nevertheless, it must flourish under a cloud of suspicion, jargon, wind, and wool, much of it deserved.
Since 2009, 8,500 graduate students from 300 business schools, including Harvard and Wharton, have taken an oath1 laying down what the future business executive must do in his professional life to satisfy his own conscience, the requirements inherent in his profession, and the community at large. The oath is manifestly written for the use of future chief executives of businesses of a certain size, with access to labour and capital markets, including a stock market for their shares. It is not really written for owner-managers of private companies, although some of the text may be applicable to them as well. This oath consists of seven articles. Two of them are relevant to the present argument that seeks to substantiate the claim of confused thinking.
Article 1: “I will manage my enterprise with loyalty and care and will not advance my personal interests at the expense of my enterprise or society.“
“The chief executive takes an oath to be loyal, but his promise is an almost empty one, because he promises to be loyal to everybody and anybody without establishing a rank order between all his loyalties.”
The chief executive, in other words, takes an oath to be loyal, but his promise is an almost empty one, because he promises to be loyal to everybody and anybody without establishing a rank order between all his loyalties. There is no question of being particularly loyal to the shareholders who are paying his salary. It is not always, but nevertheless often, that the interest of one group can only be enhanced by diminishing the interest of one or more other groups. The article implicitly regards the interest of anybody concerned as being coextensive with the interests of everybody else. This is fairy tale land or nearly so, because, in most situations, the interests in question compete with one another. You cannot give more to one without taking away some from the others.
The attempt of the business manager to be the judge of who gets something at the expense of taking something away from the others would in many instances result in Solomonic verdicts with the result being worse than if no judgment had been proclaimed.
Article 7: “I will develop both myself and other managers under my supervision so that the profession continues to grow and contribute to the well-being of society.“
This article is designed to persuade public opinion that business management has the same ethical rank and authority as older professions such as medicine and the law. This article is manifestly “self-interested”. This claim is in itself a demonstration of confused thinking.
As a result of past events, a business disposes of resources of labour and capital. It seeks to deploy them in such a way that the marginal resources invested in labour will result in the same level of profit as the marginal resources invested in capital, so that no redeployment of the same resources could produce a larger profit. The business will try and maintain this equality over time into the future, with successive and progressively farther time periods eventually qualifying as the “long term”. However, the result in every time period is not a single quantity of future profit, but several quantities of alternatives, with each alternative having an estimated probability of occurring. Moreover, this probability distribution may be estimated by each shareholder differently, and thus may differ according to the information available to each shareholder as well as the temperament of each. Ideally, the chief executive as an agent of the shareholders would conduct the business so as to represent a single quantity of a long-term profit. This single quantity would in some sense represent all the expectations of the shareholders with all the probabilities attached to them. For obvious reasons, of which the information relating to each shareholder is only one, it is impossible to compose such a representative number. Instead, the chief executive must compose the number representing long-term future profit as a matter of his own responsible judgment.
Long-term profit implies a result that we obtain via short-term profits.
“Short-termism” is a reproach the investment community often makes to the chief executive. “Long-termism” would be just as justified, perhaps more so. Short-term profit is the most recent information one can have about the long-term profit which remains only a forecast. Whether the short-term profit is under- or over-fulfilled on the way to the long-term is the only information about it; the rest of the way towards the long-term has an irreducible subjective element. The short-term information may of course give rise to adjustments in labour or capital or both for the remainder of the way towards the long-term profit.
The result from the profit-and-loss account is divided between the dividend and the retained profit. The retained profit must promise an adequate return in terms of future profit so as to compensate for it not being distributed as a present dividend. Future profit yielded by the retention must, in turn, be adequate to satisfy the forecast of long-term profit. In equilibrium, there would be no further call for adjustment between the dividend, the retained profit, and the future long-term profit.
For more on these topics, including what economists call the problem of agency, see the EconTalk podcast episode Zingales on the Costs and Benefits of the Financial Sector. See also Corporate Governance, by Randall S. Kroszner in the Concise Encyclopedia of Economics.
As far as logic can carry it, the above equilibrium satisfies a sketch of a theory of a publicly traded for-profit.
This sketch has almost nothing to do with the oath the professionally trained chief executive is supposed to obey. He must obey what all his colleagues of professional business school graduates must do, namely to contradict elementary logic and pursue mutually contradictory and confusing practices. They must persuade themselves that they are heading a business which, as the previous version of the oath stipulated, will satisfy “shareholders, co-workers, customers and the society in which [they] operate” as well as “those who may not have power, but whose well-being is contingent on [their] decisions”.
With due respect, only the brain of a zombie can fulfil an oath which obliges him to contradict, together with the same zombies what a “well-ordered” brain would command him to do.
The State is also available online on this website.
For more articles by Anthony de Jasay, see the Archive.