Corporate-Style Profit Maximization is Harming the Economy
Corporate-Style Profit Maximization is Harming the Economy
One of the basic tenets in the teaching of economics is that the goal of a business is to maximize profit. Economic theories and concepts hinge on the idea that all activities and decisions made by entrepreneurs and managers of for-profit organizations are motivated by profit-maximization.
Businesses earn revenue. In doing so, they hire factors of production (land, labor, capital). These factors impose costs on the businesses. The goal of a business is to maximize profit which mathematically is equal to revenue minus cost. This is basic economics. It is also basic accounting.
According to the teaching of economic theory, the idea that all business decisions are based on the profit-maximizing motive is not only good for the economy, but it is also a vital part of the benefits of having a market-based economy. Profit sends out the necessary signals for reallocating resources. Without these signals generated by the profit motive, resources will not be allocated efficiently. Consumers will suffer. The standard of living will be below its potential.
If a company makes widgets, then its business decisions will be based on a determination of which combination of resources will earn the company the most profit through the sale of widgets. Management will have to decide how many widgets to make, which combination of inputs to use, where to get the inputs, what kind of trade-off between quality and cost to use, how to market the product, and much more. These are the types of decisions which can vary from one company to another, even from one manager to another. But they are all based on the underlying motive of maximizing profit through the manufacture and sale of widgets.
This profit-maximizing motive in turn creates more economic efficiency in the economy. The company itself will earn more profit if it allocates its resources with more efficiency. The industry and the overall economy will both become more efficient through signals generated by existing profits. Profit-seekers will leave less-efficient industries and instead put resources into more-efficient industries. As long as more profit can be made by doing something different, then profit-seekers will choose to do something different. An industry with large profits will attract more competitors, which will reduce the profits of individual companies until the motivation to enter the industry is gone. An industry with losses will have businesses leaving the industry, as profit-seekers move into more profitable activities. An industry will be in equilibrium only when each company makes enough profit so that it can remain in business without being motivated to leave, but not so much profit that it attracts more competition. At that point, efficiency will be reached.
The part in the last paragraph about “enough profit so that it can remain in business” means that a certain amount of profit is necessary for each company. The concept of “normal profit” comes into play. Normal profit is the amount of profit required to maintain equilibrium, and therefore is a cost of doing business. The equation “profit equals revenue minus cost” is an accounting equation. When you add normal profit to the cost side, the mathematical result of the equation is called economic profit. Equilibrium exists when economic profit is zero. If economic profit is negative, then this signals that resources will be allocated elsewhere, and that businesses will leave the industry. Negative economic profit indicates that resource allocation is inefficient, and a reallocation will occur. If economic profit is positive, then this signals that more resources will be allocated into the industry, and that businesses will enter the industry. Positive economic profit also indicates that resource allocation is inefficient, and a reallocation will occur. Only when economic profit is zero will efficiency and equilibrium result.
Those are the basic points of the theory behind the role that profit plays in the economy. I provided a short version of this theory in order to better illustrate my main point, which is that the role of profit for corporations has been divorced from the benefits of economic efficiency to a large degree.
Profit is equal to revenue minus cost. Business decisions are based on attempts to maximize this equation. A widget manufacturer will be motivated to maximize the bottom line on an income statement.
But this is not true if the widget manufacturer happens to have a corporate structure. The bottom line on an income statement is a factor, but it is not the only factor. You will note that the theory of efficiency requires ALL business decisions to be directed towards that bottom line. But for corporations, this is different.
You might think of profit as being the bottom line on an income statement, and the basic theory of efficiency would agree with you. But corporations don’t think that way. To a corporation, profit means “shareholder value.” A corporation is NOT motivated to maximize accounting profit on an income statement. A corporation IS motivated to maximize shareholder value.
That’s right. The sole purpose of any corporation is to manipulate stock prices.
There is a theoretical basis for this. You can even find that theory in economics textbooks. The theory is that for a corporation, the business itself is a mythical entity which owns nothing, and earns no profit. The stockholders are the ones who own everything. Maximizing stockholder return IS what corporate profit is all about. (I’m not sure how this theory supports the notion of corporate personhood)
The term “maximizing profit” is rather loosely defined in economic theory. For one thing, it can refer to activities designed to increase current profits; or it can refer to activities which reduce current profits in favor of future profits. Different competitors within the same industry can operate under different ideas of what “profit” means to them, yet economic theory says that each has the same goal of maximizing profit. In the corporate world, changing this definition to “maximizing shareholder value” encompasses a whole new set of business activities.
But theory aside, what is the real-world result of equating profit with shareholder value rather than with the income statement?
As I said above, the bottom line on the income statement is part of the equation. But it isn’t the only part. Corporate decision-makers are free to do just about anything that they can justify as “maximizing shareholder value.” Increasingly, they are using their resources on things that are not related to the income statement. Increasingly, they are making corporate decisions which do not contribute to the economy’s efficiency or the overall standard of living. To put it another way, corporate decisions are increasingly divorced from the production of widgets.
Take a look at corporate newsmakers. Read the financial pages. What are these news stories about? What are corporations making news for? Are they in the news because of operating profits? Is it for activities which contribute to the overall economy? Or are they in the news for activities directly related to the manipulation of stock prices? Is the money going into the “real” economy, or is it contributing to a stock market bubble?
Mergers, divestitures, stock buy-backs, tax inversions, lawsuits, lobbying congress, lobbying stockbrokerage firms, and using the media to spread propaganda are just a few of the activities which corporations are increasingly engaged in – activities not necessarily related directly to the production of widgets, so to speak. Some of these activities can actually be justified under economic theory. Do the activities increase or decrease competition and its resulting effects on the efficiency of the economy? Perhaps a decrease in competition can be justified as an increase in economies of scale. But the theory only works in the real world under specific circumstances. The theory probably doesn’t apply for activities which are conducted with only the effects on stock prices in mind.
What about corporate campaign spending? Does anybody believe that corporations finance political campaigns out of a sense of patriotism, willing to sacrifice billions of dollars with no thought of receiving a return on this investment? Or is it more likely that they are telling politicians that if they want to get elected, the politicians had better provide corporations with a healthy return on the investment?
And how, exactly, is campaign spending going to help corporations to produce widgets?
For more information on the problems of corporate activities in the real world, and ideas on what can and should be done about these problems, see my essay “Corporations and the Public Interest: Lessons from History”.
A version of this essay is included as a chapter in the book Common Misconceptions of Economic Policy by Jerry Wyant. You can purchase this book in paperback form from Amazon and other online book distributors. The list price is $12.99 (only $9.99 using discount code TA9GTK7E when ordering, depending on the distribution channel). Or if you prefer, you can download a digital version on your device (Kindle, Nook, etc.) for $4.99.
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