The origins of the profit constraint

Fifty years ago, Milton Friedman published his landmark work The Social Responsibility Of Business Is to Increase Its Profits in The New York Times Magazine. [0] A reaction against the surging support for social justice in 1970, the essay would go on to influence the course of economics and corporate governance for the next half century.

Friedman’s argument is rather simple. In a business, decisions are made by managers employed by the owners of the business. Managers thus have a contract to run the business consistent with the objectives of its owners. In some cases, a business may be established by its owners for social, environmental, or other charitable purposes. For non-charitable businesses, according to Friedman, the owners want the business to make as much money as possible. The power of Friedman’s argument is it gives managers a simple model for decisions: maximize profit.

This optimization model lies at the heart of the modern corporation. It is the pacemaker of shareholder capitalism. New insights from the science of complexity, however, are showing this pacemaker has a flaw.

Company Origins

A company is an organization that enables individuals to pool resources for risky, long-term projects. Companies are designed and built for a purpose, they distinguish between members and nonmembers, and have systems to accomplish work. [1]

The most important organization in the world is the company: the basis of the prosperity of the West and the best hope for the future of the rest of the world. Indeed, for most of us, the company’s only real rival for our time and energy is the one that is taken for granted—the family. [2]

The concept of a company can be traced back to ancient Mesopotamia. Commercial activity during this time was conducted mostly by simple bartering, but more complex arrangements emerged with Sumerian (3000 BCE) property contracts and Assyrian (2000-1800 BCE) business partnerships. [3] In the 4th century BCE, the Athenians developed business models for maritime commerce in the Mediterranean. These businesses were open to outsiders and based on the rule of law rather than royal authority.

A century later, Romans developed some of the fundamental concepts of what we now call corporate law. While most wealth in the Roman Empire was concentrated in agricultural and private estates, Roman societies established a collective identity with partners owning shares of the business. The partners delegated managerial decisions to a magister who ran the business and kept financial records. Romans also formed partnerships called peculiums run by a slave. Peculiums provided protection for the partners from creditors—limiting liability to the assets allocated to the business. Following the collapse of the Roman empire, the organization of commercial activities developed more slowly through the Middle Ages followed by a new wave of innovation in Renaissance Italy. [4]

Renaissance Innovations

By the 12th century, northern Italy was the center of European finance and commerce. City-states in the region dominated Mediterranean maritime trade and served as a gateway for crusaders traveling to the east. Commercial activity was often organized as compagnia through which fathers, brothers, sons and other relatives would pool their labor and capital. [5] As they grew more sophisticated, compagnia began attracting money from outside the family circle, further expanding the pool of capital and spreading the risk of the venture.

Florence is said to be the birthplace of the Renaissance, and in the early 14th century three Florentine families dominated finance in Italy—the Bardi, Peruzzi, and Acciaiuoli. All three families were wiped out following the default of King Edward III of England and King Robert of Naples in the 1340s. This left an opening for another Florentine family—the Medici—to seize control of the Republic. The Medici family would go on to build a business empire that left an enduring mark on the region.

Giovanni di Bicci de Medici launched the family business by landing the Vatican’s account in the 1380s. [6] Vast sums of money in many different currencies flowed through the papacy’s accounts, and Giovanni built a reputation as a currency trader. Over half of the Medici’s revenues came from their branch in Rome, and they used the profits from this business to diversify into trade, lending, textile manufacturing, and other businesses—including a monopoly on key chemicals used in the textile industry. [7] By the middle of the 15th century Giovanni and his son Cosimo had built one of the largest business empires of their time with branches in Florence, Venice, Rome, Geneva, London and other cities.

Rather than operate as a single organization, the Medici built a decentralized network with each new branch or business set up as an independent partnership between local businessmen and senior partners back in Florence. Each branch managed their own books and accounts, and were audited each year by the senior partners. This decentralized structure created strong incentives for the local partners to run a profitable business. It also allowed the Medici to maintain firm control of a sprawling empire and shield the assets of the broader business from the liabilities at each branch where the local partners where “first in line” to account for any losses. [8]

The Medici’s success in business brought substantial wealth and political influence. According to financial historian Niall Ferguson, “No other family left such an imprint on an age as the Medici left on the Renaissance. Two Medici became popes (LeoX and Clement VII); two became queens of France (Catherine and Marie); three became dukes (of Florence, Nemours and Tuscany).” [9] They also were patrons of some of the greatest artists and scientists of the era (and all time) from Michelangelo to Galileo, and left an architectural legacy in Florence that people travel from all over the world to see to-this-day.

Two hundred kilometers to the north of Florence, the Republic of Venice was a maritime power that rose to commercial prominence by controlling the salt trade with the Byzantine Empire. “Unlike the other Italian city-states, Venice put the demands of commerce high above the rule of the Church… and was excommunicated several times during the fifteenth century.” [10] Commercial prominence and political pragmatism in Venice led to a number of business innovations. The first state bank of Europe was opened in the Rialto, the market at the center of the city, which dominated international currency exchange throughout Europe for over 300 years. Businessmen from all over the region would travel to the Rialto to learn the secrets of finance and commerce.

Venetian bankers and merchants also perfected the system of double-entry bookkeeping—initially developed by Florentine merchants in the late 13th century—which allowed them to systematically track business assets and liabilities, and, most importantly, calculate profits. [11] Luca Pacioli—the famous mathematician from Sansepolcro and companion of Leon Battista Alberti and Leonardo de Vinci—published a treatise on mathematics in 1494 with a chapter on bookkeeping that became the definitive guide to the Venetian method, the foundation of modern corporate accounting centuries later.

In today’s profit-driven commercial world we are more than familiar with the idea that the purpose of every business is to make a profit. But Pacioli was writing in an era when this was not so self-evident and the tools for calculating profit—especially the Venetian bookkeeping system—were not widely used. And so he makes it clear that the purpose of every merchant is ‘to make a lawful and reasonable profit so as to keep up his business’. [12]

Charter Companies

Merchants in northern Europe built on the innovations of the Roman Empire and Renaissance Italy, developing guilds, charter corporations and ultimately the joint-stock corporation. Throughout the Middle Ages, the concept of a separate, collective identity (a “corporate person”) was used by northern European towns, universities, and religious communities. Trade guilds were important organizations in this period as well. They were given a monopoly over their trade within a city by the sovereign, set standards for quality, and selected and trained new members.

The first charter companies were formed in the 12th century and operated like guilds with a group of merchants banding together to sell goods under a single organization. Charter corporations straddle the public and private sectors, forming a business venture with a charter from the sovereign for exclusive rights to a commercial activity within the city. Like trade guilds and merchant associations, they provided a means to transfer customs and knowledge to future generations. They also provide a means to transfer considerable wealth. The Corporation of London, for example, still owns a quarter of the land in the City of London. [13]

Mining, shipping, and milling corporations offered shares on the open market as early as the 13th century, and by the 16th and 17th centuries these ideas would come together to empower the “combined effort of governments and merchants to grab the riches of the new worlds.” [14] The Portuguese were pioneers in exploring the East Indies with state-led expeditions. The Dutch and English, in contrast, raised money for voyages with new public-private ventures formed as chartered joint-stock companies. This structure had the monopolistic advantage of the charter corporation. It also pooled capital and risk for the venture by selling tradable shares on an open market. To attract investors, shares often limited shareholder liability to their original investment.

The first chartered joint-stock company was the Muscovy Company, formed in England in 1555. The Muscovy Company received an exclusive charter for trade with the Russian czar Ivan IV at the port of Archangel, and was encouraged to search for a northeast passage to the East Indies. In the 1580s, the Virginia Company was chartered by Elizabeth I to explore and colonize America. It was based on Richard Hakluyt’s Discourse on Western Planting (1584)—arguably one of the first company prospectuses—and raised funds from some seven-hundred investors including Sir Francis Bacon. [15] The Muscovy Company, the Virginia Company and other early joint-stock companies raised funds for individual voyages with proceeds divvied up upon return. This pooled capital and contained shareholder’s risk to individual voyages. The Dutch developed a more durable structure which would be the model for future joint-stock companies.

In 1602, Dutch merchants received a charter forming the Dutch East India Company (also known as “VOC” for Vereenigde Oost-Indische Compagnie). VOC was a true public-private venture with the government providing both the charter and owning a stake in the company. VOC’s first charter locked shareholders’ investment for ten years. In 1612, the government changed VOC’s charter preventing shareholders from recalling their original investment for an indefinite period of time. This was a significant departure from early joint-stock companies, which were set up to pool resources and diversify risk for individual voyages. By extending the commitment to ten years, and then indefinitely, the Dutch developed the concept of an immortal company, creating a durable asset that would produce wealth over long periods of time. It also led to a vibrant secondary market for shares of the company. This meant shareholders were not stuck with their investment and could even profit from trades in the secondary market, while ensuring VOC had a stable asset pool to continue exploiting their dominance of Far East trade routes. [16]

The English also fought for control of trade in the East Indies. The English effort was led by English East India Company (the “Company”). Formed in 1600 by a group of 218 merchants and adventurers, the Company received exclusive rights for 15 years to trade in the “Indies,” an area that was defined as extending from the Cape of Good Hope to the Straits of Magellan. [17] In contrast to the VOC model, the English East India Company was a private organization—authorized by a charter but not owned by the crown—and voyages were funded independently until it became a permanent joint-stock company in 1657.

By 1620, the English East India Company had over 30 large and heavily armed ships, which traveled in convoys of 12 or more vessels, were operated by over 2,500 sailors, and maintained by 500 carpenters. [18] Typical voyages were 16 months long, leaving on the eastbound leg in the winter with silver and other metals, armor and swords, satins and broadcloths, and other tradable goods. In India, these were traded for cotton textiles, which was then traded for pepper, cloves, and nutmeg in the Spice Islands. Some voyages continued on to China, Japan or the Philippines for silk, indigo, sugar, and coffee. Most voyages returned through India where spices were traded for tea. [19]

To manage this complex trade network, the Company’s day-to-day activities were run by 24 governors who oversaw a network of resident “factors” at local trading posts or factories, and a growing administration of accountants, clerks, and other specialists organized into 7 committees: accounting, buying, correspondence, shipping, finance, warehousing, and private trade. Governors were elected by shareholders of the Company, who reaped large returns on their investment. [20]

The Modern Corporation

Despite the success of early joint-stock companies, a series of scandals in the early 18th century led to the English Bubble Act of 1720. The Act required every joint-stock company to receive a charter from parliament. To avoid the cost and uncertainty of obtaining a charter, most businesses in the burgeoning industrial sector preferred partnership arrangements. Many industrialists also believed the detached ownership of shareholders was not an effective business structure, preferring hands-on ownership arrangements. This began to change with the large sums of capital needed by the British rail industry in the early 19th century. By 1840, over 2,000 miles of track was laid by publicly traded, joint-stock companies, spurring the government to reform the joint-stock structure.

Starting in 1844, the British government passed a series of Acts that formed the foundation of the modern corporation. They first allowed the creation of a joint-stock company by registration rather than charter. They also required companies to disclose financial information audited by someone other than directors of the company and required dividends to be paid out of profits rather than capital. By 1862, they established automatic limited liability protecting shareholders from the corporation’s debt burden, thus limiting their liability to their original investment. At the same time, investors could draw dividends from the corporation, extracting profits that might otherwise be collected by debtors.

The U.S. can trace its founding to the corporate form. The colonies were originally organized as corporations chartered under the British crown, planting the seeds of democracy and the context within which the Framers wrote the Constitution. New York was the first state to enact an incorporation statute in 1811. Similar statutes eventually spread to all fifty states. In the U.S., states rather than the federal government have jurisdiction over corporate law, allowing corporations to engage in legal arbitrage and choose the state laws they are governed by.

In fact, 68% of all U.S. publicly traded corporations and 89% of companies with initial public offerings are registered in the state of Delaware, ranked as one of the most “investor-friendly” jurisdictions. [21] In Delaware, corporations can pay dividends from the current year or previous year’s profits, allowing the company to smooth shareholder returns even if it may not be in the corporation’s long-term interests. With the expansion of global trade in the late 20th century, an “empire of law” has formed that is no longer tied to specific states but is a fluid system that allows asset holders to choose between their local laws or those of a foreign market. “For the global capitalists, this is the best of all worlds, because they get to pick and choose the laws that are most favorable to them without having to invest heavily in politics to bend the law their way.” [22]

U.S. industrialization in the early 20th century brought with it a number of changes to the nature of the corporation. Ford brought together a production system that made cars more efficiently than any human institution before it. To manage the massive enterprise the production techniques both enabled and necessitated, Ford brought as many activities under its control as possible—from raw materials to ships and railroads. This presented significant challenges for the company. There was little synergy between the desperate industries it controlled, and Henry Ford centralized all decision-making powers in one person—himself. One of Ford’s competitors, General Motors (GM), capitalized on these weaknesses, developing new management techniques that complemented Ford’s production techniques, and brought together the complete system of mass production. [23]

GM’s president Alfred Sloan developed a new corporate structure that separated profit centers—major components like generators and steering gears as well as foreign subsidiaries—into independent divisions. Managers at the corporate level focused on corporate affairs and financial oversight of the divisions, leaving the details of operating each division to its respective general manager. This structure elevated the importance of the finance and marketing professions, and embedded corporate financial management in the modern corporation structure.

The Profit Constraint

Economists often view companies as a “legal fiction” behind which lies a nexus of contracts with investors, managers, employees, and customers. [24] “If there is a nexus of contracts, it is with the legal entity, not with the entity’s stakeholders; calling this central node a fiction denies the ingenuity of this legal device.” [25] The modern corporate form is immortal, it can own property, and it shields its owner’s losses by shifting liability to others. [26] The structure also is a more efficient vehicle for creating capital and labor income compared to individual proprietors (freelancers).

Capital can take many forms. It is created from an asset—land, debt, knowledge, and others—that is coded into law conferring special properties on the asset that privilege its owner. Even humans can be capital. This is as true today as it was before slavery was abolished with the 13th Amendment. It also is contrary to the textbook economic growth model—proposed by Solow and Swan back in 1956—where capital and labor are considered independent inputs to production. [27] And yet it happens every day. “Many a freelancer, for example, has discovered that she can capitalize her labor by establishing a corporate entity, contributing her services to it in kind and taking out dividends as the corporation’s shareholder in lieu of a salary—thereby benefiting from a lower tax rate.” [28]

A freelancer is both owner and employee (principal and agent), and so human capital and non-human capital are enmeshed. In an organization, there is greater separation between principal and agent, and the degree of separation has increased with the evolution of the corporate form. Early companies—from Roman societies to the Medici and even 19th and 20th century titans like Standard Oil and Ford—were typically owned and managed by a single family or a small group of investors. The introduction of the limited-liability, joint-stock company with shares traded in public markets created organizations owned by dispersed stockholders who are unable to exert much control over management decision-making. [29] This separation is why Friedman’s essay makes a clear distinction between freelancers and organizations. It also makes Friedman’s simple argument compelling, operationalizing the pursuit of profit as maximizing shareholder value.

The separation between principals and agents, however, highlights the complexity of modern corporate organizations. The Neoclassical framework Friedman’s argument is based on assumes humans are inherently rational and self-interested. And where individuals seek to maximize their own self-interest, this manifests collectively as seeking to maximizing a company’s profit—employees want to ensure they are paid for their labor and owners want to earn a profit on their (equity) capital.

Humans and organizations, however, are complex systems shaped by evolutionary forces. As with any evolutionary system, the behavior they develop is driven by survival and replication (or amplification), not pure self-interest. [30] Even charitable organizations are fundamentally driven by survival and amplifying (or replicating) their charitable mission. This does not mean that profit is irrelevant. In fact, the gap between Friedman’s Neoclassical framework and one based in evolutionary theory and complexity science is narrower than one might think. What these new insights provide is a reformulation of the optimization model. “In evolutionary systems, profitability is not an objective in and of itself; rather, it is a fundamental constraint that must be met if a business is to achieve the objective of survival and replication (or enduring and growing)…”

…eating is a constraint on living (and a very vital one), but no one would claim that the purpose of life is to eat. [31]

References

  1. Friedman, M. (1970, September 13). The Social Responsibility Of Business Is to Increase Its Profits. The New York Times Magazine, p. 32–33 & 122–126. Retrieved from https://www.nytimes.com/1970/09/13/archives/a-friedman-doctrine-the-social-responsibility-of-business-is-to.html

  2. Beinhocker, E. D. (2006). The Origin of Wealth: The Radical Remaking of Economics and What It Means for Business and Society. Boston, MA: Harvard Business School Press, p. 351-352.

  3. Micklethwait, J., & Wooldridge, A. (2003). The Company: A Short History of a Revolutionary Idea. New York: Modern Library, p. xv.

  4. Micklethwait & Wooldridge, 2003, p. 3.

  5. Micklethwait & Wooldridge, 2003; Abatino, B., Dari-Mattiacci, G., & Perotti, E. (2009). Early Elements of the Corporate Form. Oxford Journal of Legal Studies (Vol. 31).

  6. Robins, N. (2012). The Corporation That Changed the World. Pluto Press, p. 22.

  7. Micklethwait & Wooldridge, 2003

  8. Gleeson-White, J. (2011). Double Entry: How the Merchants of Venice Created Modern Finance. New York: W. W. Norton & Company; and (Micklethwait & Wooldridge, 2003)

  9. de Roover, R. (2017). The Rise and Decline of the Medici Bank, 1397-1494. Borodino Books; and (Pistor, 2019)

  10. Ferguson, N. (2018). The Ascent of Money: A Financial History of the World (10 ed.). New York: Penguin, p. 39.

  11. Gleeson-White, 2011, p. 50-51.

  12. Gleeson-White, 2011

  13. Gleeson-White, 2011, p. 97.

  14. Micklethwait & Wooldridge, 2003

  15. Micklethwait & Wooldridge, 2003, p. 17.

  16. Micklethwait & Wooldridge, 2003, p. 19.

  17. Pistor, K. (2019). The Code of Capital: How the Law Creates Wealth and Inequality. Princeton, NJ: Princeton University Press.

  18. The National Archives. Charters of the East India Company with related documents: the “parchment records.” Retrieved August 30, 2020, from https://discovery.nationalarchives.gov.uk/details/r/16e42ef9-0b6c-4f6e-acb6-27cac99de0b4

  19. Micklethwait & Wooldridge, 2003, p. 23; Robins, 2012, p. 19.

  20. Robins, 2012

  21. Robins, 2012

  22. Delaware Division of Corporations. 2019 Annual Report Statistics. Retrieved August 30, 2020, from https://corpfiles.delaware.gov/Annual-Reports/Division-of-Corporations-2019-Annual-Report.pdf

  23. Pistor, 2019

  24. Womack, J. P., Jones, D. T., & Roos, D. (1991). The Machine That Changed the World. New York: Harper Perennial.

  25. Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305–360.

  26. Piketty, T. (2013). Capital in the Twenty-First Century. Cambridge, MA: Belknap Press, p. 52.

  27. Pistor, 2019

  28. Solow, R. M. (1956). A Contribution to the Theory of Economic Growth. The Quarterly Journal of Economics, 70, 65–94.; and Swan, T. W. (1956). Economic growth and capital accumulation. Economic Record, 32(2).

  29. Pistor, 2019, p. 11.

  30. Winkler, A. (2018). We the Corporations: How American Businesses Won Their Civil Rights. New York: Liveright, p. 205.

  31. Beinhocker, 2006

  32. Beinhocker, 2006, p. 410.