Wednesday, 8 October 2014

The Profit Motive and Capitalism

The pursuit of self-interest is the second pillar of capitalism and it is expressed by the profits attained. Without profits companies would not know whether an item or service is worth producing and could not measure their success. As remarked by Adam Smith (1776), “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”.

Profits, or net income available to common shareholders to use the accountant’s terminology, are the difference between revenues and expenditures. The outlays include the compensation to suppliers, the taxes paid to governments and interest charged by creditors. This residual amount belongs to shareholders and may be distributed as dividends or kept in the firm as retained earnings.

Contrary to what some finance theories imply, profits may not be considered as a cost to be minimized but rather as a gain to be maximized. Yet, many still see profits as immoral or as something to be curbed rather than maximized because they encourage selfishness and greed.

The immorality of profits is preached by Marxists and some religious leaders. The later invoke arguments similar to those used in the Middle Ages to condemn charging interest on loans. The first appeal to Marx’s mistaken labor theory of value postulating that all goods, considered economically, are only the product of labor and cost nothing except labor. Both doctrines have been refuted by theory and history.

Nonetheless, the need for profit maximizing capitalists or firms is repeatedly debated and needs to be clarified. The debate involves three main topics – whether humans are really optimizers or satisfiers, if it is indispensable for optimal competitive markets and the likelihood of degenerating into a socially unacceptable concentration of wealth.

In relation to the first, recent research on human behavior shows that humans are often driven by motives that cannot be considered as self-interest. However, the proponents of self-interest maximization claim that such deviations are minor and that maximization is still a good proxy for human behavior. The risk of wealth concentration is real, but it is naturally bounded through diseconomies of scale and may be socially constrained through inheritance and income taxes. So, we focus on its indispensability for an optimal allocation of resources through competitive markets.

The idea that the profit motive is dispensable or at least is not foremost in modern capitalism stems from the widespread view that in a world where ownership is very removed from control companies have many stakeholders and that shareholders are merely one of them.

However, in competitive markets, the interests of other stakeholders are better served by shareholders pursuing profit maximization motives. One does not need to endorse Ayn Rand’s (1964) reclassification of selfishness and greed as virtues rather than evils. We can rely on Aristotle’s concept of mean or on Keynes (1936) statement that “it is better that a man should tyrannize over his bank balance than over his fellow-citizens” in the pursuit of his money-making passion subject to rules and limitations aimed at creating a levelled playing field.

Indeed, the profit motive is indispensable in both competitive and oligopolistic markets but the prevalence of one type of market over the other is not indifferent.

Let us illustrate first why the shareholders profit motive is indispensable, despite the current trend in finance theory to focus on firm value rather than shareholder value. Under such theory the manager’s role is to maximize the present value of future cash-flows discounted by the weighted average cost of capital. Assuming the possibility of risk-free arbitrage between debt and stock securities issued by a company or that stocks always sell at book value then the structure of capital would be irrelevant to determine the value of a firm. Thus the managers objective should be the maximization of operating profits (EBIT) rather than the shareholders profit (net income). Moreover, managers could ignore the owners’ desired debt/equity ratio because they can achieve whatever level they wished by leveraging their equity portfolio.

However profit maximization cannot be pursued regardless of who has claims on operating profits, that is, debt holders, tax authorities, shareholders and managers (retained earnings). In what concerns debt holders and taxation the company has a duty to minimize their share by procuring the cheapest source of financing and reducing its tax bill. Retained earnings could be a maximization objective. However, if we accept the proposition that the capital structure does not affect the value of the firm, then even managers trying to maximize the size of their company should be indifferent about whether its growth was financed with internal or external funding and may not feel compelled to maximize retained earnings. Therefore, only shareholders have a genuine and unequivocal interest in profit maximization, regardless of the degree of separation between ownership and control.

That is, shareholders are indispensable for profit maximization irrespective of whether they prefer capital gains or distributions (dividends and stock repurchases).

This is an important conclusion because, theoretically, a corporation could be established by any of the so-called stakeholders - employees, managers, clients, governments, creditors, entrepreneurs and shareholders – interested only in maximizing their own return (e.g. salaries or executive compensation) and minimizing that of the other stakeholders. Even if we consider the so-called serial entrepreneurs, who are successful at finding and developing new business opportunities and are driven more by the entrepreneurship thrill than capital gains or control, they still need the profit motive of passive shareholders to compel management to pursue profit maximization and secure the success of their ventures.

Finally, let us discuss if the profit motive is efficient and indispensable in all human activities and organizations, and in particular for big businesses operating in oligopolistic markets. In the case of public goods and services it is normal that the objective is not the maximization of the financial return for those who provided the funding (taxpayers), but rather the minimization of the cost for the consumers of such services. Likewise, in the case of philanthropic and other non-profit organizations, the objective is not to maximize the donors satisfaction but to maximize the beneficiaries benefit. Although in these organizations we may find many instances where the interests of the ultimate beneficiaries have been hijacked by the interests of the insiders (e.g. politicians, directors, officers or employees) they still cannot be driven by the profit motive.

Fortunately, most human needs are better fulfilled by for-profit organizations. Yet, except under special circumstances, the pursuit of profit maximization does not guarantees Pareto efficiency in the case of markets dominated by oligopolistic firms capable of securing monopolistic rents. So, while profit maximization is an essential foundation of capitalism it needs to be complemented by competitive markets.

In a world where most people is to a greater or lesser extent a passive capitalist increasingly removed from the control of his investments and there is a growing oligopolization in many industries we need to understand how capitalism depends on the preservation of free and competitive markets.

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