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Economics

Profit as an indicator of success

A talk by Philip Booth to the Corporate Responsibility Group Exchange, September 2010

In recent years “profit” has become something of a dirty word and corporations have been encouraged to seek wider social goals following an agenda of so-called “social responsibility”. I would like to start by saying a word or two in defence of “profit”. As the pope has just been here, I am going to start by referring to Catholic social teaching – and then I will not refer to it again explicitly. The Compendium of the Social Doctrine of the Catholic Church describes profit as an ‘indicator’ that a business is performing well and that the productive factors have been properly employed. This is true – profit is a signal that important ends are being achieved by a business.

In economic terms, profit is the return from entrepreneurship. Entrepreneurship, in turn, involves the discovery of forms of economic activity that lead to the fulfilment of a hitherto unfulfilled need or that fulfil existing needs more effectively. The mobile phone, artificial hip and so on are all products of entrepreneurship. Profit is an indicator to the entrepreneur that he has been successful in creating something of value to others. Even an individual who had no material desires whatsoever, who wanted to give to charity all his profits, may wish to consider a vocation of entrepreneurship which involves industrious attempts to make profits because the profits would be an indicator that he was producing something of value to others.

Profit-making businesses are ‘social’

This is a justification, of course, for the pursuit of profit maximisation. Profit-making businesses are inherently social – they do not have to be made so. Those who make profits use their intelligence and initiative to be of service to others. If they were not of service to others, they would not make profits. I hope when I have left that you do not bring up the banks as a counter example. Insofar as they are underwritten by the state, they do not form part of the market economy. Entrepreneurship is an intrinsically social activity in just the same way that people often see teaching, nursing or working for charities as intrinsically social activities. Any business needs to be “other regarding” if it is to make a profit because profits can only be made by selling things of value to others. Serving others is not the objective of those running the business but it is an indirect result.

People complain that profit-motivated businesses are motivated by greed and selfishness. Professor Ken Starkey of Nottingham University is one of many who has written about the problems of business schools teaching that “greed is good”. However, this analysis is wide of the mark. Markets generally harness self interest – a motive quite different from that of greed and selfishness with which the term is often conflated – to good use. In diligently pursuing my own objectives in business, I can only generally succeed if I fulfil the needs of others.

Not all profits are morally acceptable

This does not, of course, mean that all activities that lead to profit are morally acceptable. There are many different ways in which gravely immoral acts might be performed in the pursuit of profits. For example, businesses can, in particular circumstances, use their power to ride roughshod over the property rights of others. Mining companies may bulldoze houses ignoring the wishes of the owners; some businesses may destroy forest areas without providing appropriate compensation to inhabitants; and so on. In fact, it is one of the first responsibilities of government to protect property rights. But, if governments do not enforce property rights, businesses have a moral responsibility towards the property rights of others. Sometimes, sadly, business will be in league with the very governments that should be protecting private property and, together, business and governments ride roughshod over property rights. This cannot be morally justified. Businesses should behave in accord with the natural moral law.

Businesses should be subject to moral restraint but they should not have explicitly social aims. We should be aware that there are many types of corporations – not all businesses are corporations and not all corporations are businesses. The purpose of a profit-making business is to enrich its owners whilst serving its customers. Non-business corporations (universities, charities, NGOs and so on) may have different aims. That is fine, but we should be happy to accept the different aims of different types of corporations and not try to make businesses more like charities. Secondly, there is an issue of stewardship. The owners of businesses ultimately are persons – many, if not most, of whom are potential pensioners, not all of them particularly well off. When we ask corporations to pursue multiple aims we are asking management to make judgements about which aims to pursue in which situations and making corporate governance that much more difficult. I am in favour of corporations acting ethically – as I have already made clear. I am against a general and subjective interpretation of some notion of social responsibility by management in what is often an ethics-free moral relativist zone. Anybody who disagrees with this might want to consider that the Royal Bank of Scotland and Enron had impeccable CSR policies.

I have also been asked to discuss what I think about the future for mutuals, cooperatives, enterprises that do not maximise profit and so on. Firstly, let me say that I hope the future is bright. For all sorts of reasons, the market economy is a better place if it is made up of a rich tapestry of different types of enterprise. I am encouraged by the development of such enterprises in many fields. I think the financial sector would be better if it were more diverse. However, I would make two points to quell the excitement. In the financial field in particular, these institutions originally arose in the nineteenth century in a climate – to which I would like to return but which is not on the horizon – of very limited financial regulation. They arose to signal to consumers certain attributes that consumers valued. Modern, detailed financial regulation makes the climate that much more difficult for non-standard companies in many ways.

These issues may not apply to other sectors of the economy. But, though I would like a free economy to have a rich tapestry of varied institutions, I would like to say a word or two in defence of traditional shareholder-owned corporations.

Mutuals and worker co-operatives can be problematic from the point of view of corporate governance and corporate finance. They have a history of accumulating rather than distributing profits. Some people like that, but every pound of profits that is retained benefits the top managers and can be at the expense of the worker-owners. Also, if workers own the companies they work for, in the event of insolvency, they lose their jobs and their capital at the same time. Finally, individuals, especially those of modest means, need to save using securities markets so they can diversify their investments effectively. This is done via unit trusts, insurance companies and pension funds, of course. The limited, shareholder-owned company is a particularly effective vehicle for mobilising capital and providing returns to long-term savers.

In summary, let us defend profit-making corporations. Let us ensure that they behave in an objectively ethical manner under the rule of law. Let us celebrate the rich variety of forms of business organisation, but not forget the significant benefits of the shareholder-owned company.

5 comments to Profit as an indicator of success

  • I love the uncited statement:

    “Mutuals and worker co-operatives can be problematic from the point of view of corporate governance and corporate finance.”

    In what sense problematic? and it what sense less problematic than say an investment bank?

    In regards to corporate governance worker owners a closer and have more access to information/accounts, have more motivation for the business to succeed (as they have more at stake), and can focus more on this one business as they are less likely to have stakes in multiple businesses.

    This compares to investors, have less access to information, have more businesses to focus on, and frankly less motivation as they can always sell their shares, if they are quick enough to spot the lapse in corporate governance.

  • […] the rest of  the article on the Cobden Centre website. Tags: Catholic social teaching, corporate social responsibility, entrepreneurship, Philip Booth, […]

  • Philip

    In practice, John, it is more difficult for the owners of a mutual to discipline the management. Ownership is dispersed, shareholder activism is more difficult, monitoring is far more difficult, there are fewer incentives to monitor because it costs an individual member so much to take action. It is similar with cooperatives and you have the additional problem that there is no reason why worker-owners will have specialist monitoring skills. Mutuals were helpful at resolving conflicts of interest between customers and owners especially when contracts are opaque (which is why they were common in long-term insurance markets). The problem is that when the regulator took that function over it kind of removed the mutual’s comparative advantage (hence my other points). It is not capitalism that has killed the mutual but regulation – the data is pretty clear on this point.

  • Current

    Philip,

    I agree that cooperatives have corporate governance issues. The situation is similar to that with Democracy, but on a smaller scale.

    I’m not sure though if the regulators have taken over the competitive advantage of cooperatives completely though. At present many regulators do not display the same cynicism as other branches of the civil service. I think though, that in time that will change, it has been changing in recent years in the US.

  • […] the same for capital-allocators, or entrepreneurs. Profit (built up into investment capital) is the evidence that they are good at it, the reward/incentive to focus on capital-allocation, and the means to do […]