First Things First

Managers in corporations face familiar trade-offs all the time. How do they strike a balance between cutting costs to sustain profitability and hanging on to good people so a company can grow again when conditions improve? How far beyond government mandates should a company go with its “green” initiatives when the financial benefits are unclear?

Practically speaking, managers need some “ultimate goal”—what economists refer to as the “objective function” of the corporation. To be useful, this objective function must have a single measure of success. Objective functions that violate this constraint leave managers unable to make consistent trade-offs when navigating conflicting objectives.

For instance, suppose a company wishes to increase its current-year profits as well as its market share. It is likely that market share increases alongside profitability for a while. At some point, though, increasing market share comes at the cost of current-year profits. Charged with doing what has become impossible, namely, increasing both simultaneously, a manager will be unable to act rationally because there is no basis for consistently making the unavoidable trade-off between, say, increasing the ad budget to improve market share and holding it constant to avoid reducing profits.

So what should an organization’s single-valued objective function be? What is the one thing that matters above all else?

A widely held view is that maximizing shareholder-wealth is the only viable candidate. Corporate managers should ground every decision they make in the pursuit of financial wealth for the providers of equity capital. This belief is often defended as a moral obligation, rooted in fundamental notions of property rights. For example, the late Nobel laureate Milton Friedman asserted that shareholders own the corporation, that managers are agents of the owners, and so managers should do what the shareholders want. And it’s a safe bet that shareholders want their investments to make money, so what matters most is maximizing equity returns.

Putting shareholder wealth first doesn’t make an intractable decision easy—who’s to say whether cutting R&D or cutting sales does less harm to shareholder wealth?—but it sure can help. With a clear mandate, managers can at least focus their analytical powers on maximizing one specific outcome.

Not so fast.

A defining characteristic of corporations is their limited liability. Society grants this privilege to investors in corporations because it encourages investment and this enhances social welfare. No one’s rights would be violated if corporations were abolished and all commerce were henceforth conducted only through proprietorships or partnerships.

By accepting limited liability, shareholders give up some of the rights that usually attend ownership of an asset. Consequently, the rather uninspiring truth of the matter is that shareholders are nothing more than suppliers of capital. And just as with all other suppliers of key inputs, shareholders must be paid for their contribution in accordance with the relative scarcity of their input and the bargaining power they enjoy. Fundamentally, all suppliers are equal. Karl Marx was right: capitalism works only when employees are paid less than the full value of the contributions they make. Striking a balance between compensating stakeholders for their contributions and preserving the wealth of the corporation they serve results in a risk-adjusted return to each relevant party (customers, suppliers, employees, managers, stockholders).

But what’s a manager to do? There might not be any moral reason to put shareholders first, but for practical reasons, something has to come first. What?

How about this: the corporation. A manager’s first objective must be the survival of the corporate entity. To be sure, the corporation must responsibly compete in free and well-functioning markets for its key inputs—including capital. But the purpose of the corporation is the preservation and propagation of its own existence.

Most managers, if pressed, would admit to thinking of the tradeoffs they make in similar terms. They don’t seek to “maximize” returns to anyone, even shareholders. Rather, the best managers keep all the relevant parties happy (enough) to continue playing ball. This amounts to putting the corporation first.

And this is a good thing. Generalized to the entire economy, relentless competition between corporations for relevant inputs of labor, capital, and revenue amounts to a quasi-Darwinian selection process, and only those corporations that are able to generate sufficient risk-adjusted returns for all contributors can make the cut. As a consequence, when every corporation looks out for itself, the net winner is society at large. And that’s important, since the only reason the body politic allows corporations to exist is because they make us all—not just shareholders—better off.