The Corporation

This is a response to a students question about the split between ownership and management of a corporation.

I am not surprised that you feel confused about the separation of ownership and management in corporations, because this is a contentious area. I also teach economics. From an economic perspective, firms are most efficient when they maximize profits. This is because there are really only two legal ways to maximize profits: 1) reduce costs (create more with less), or 2) innovate (bring new products and services into existence that people want to buy). Since profits are the reward for ownership, in a corporation profit maximization benefits shareholders. Thus, a focus on benefiting shareholders by maximizing profits results in corporations that are constantly innovating and reducing the costs of production. This means faster growth and a higher standard of living for people in a country, which promotes such a system.

There is an alternative view that you often hear which talks about stakeholder interests. "Corporations should exist to benefit stakeholders." The problem is that the word stakeholders turns out to mean almost everyone (owners, managers, employees, customers, the community, etc.) It sounds good, but benefiting stakeholders is like trying to achieve a goal when there is no clear goal. It is unfocused, and in my opinion becomes rather meaningless.

Note, I mentioned that there are two legal ways to maximize profits. This is where law becomes essential. Corporations could try to maximize profits through theft, deception or through reducing costs by shifting the burden to others (e.g. pollution). Since the results of these strategies would be very damaging, we prohibit or restrict such strategies through law and steer corporations toward making profits in socially positive ways.

One critique of my position might be that we want corporations who a good neighbors and who treat their employees well. We do not want greedy companies who think of nothing but the bottom line. The response is that profit maximization is compatible with such behavior. In order to legally maximize profits a corporation will find that it is important to have a positive reputation in the community. Thus, it will make charitable donations; keep its facilities clean, and take other steps to promote a positive image. It will also find that it must compete with other businesses to retain the best and brightest employees, who are capable of generating profits. A corporation cannot treat its employees poorly and expect to be profitable. It best employees with quickly jump ship and it reputation will make it incapable of hiring talented people.

A profit maximizing corporation will also want to align the interests of employees and managers with the goal of maximizing profits for shareholders. Thus, it will have bonuses and other incentives to encourage managers to do so. As long as the interests of shareholders and managers are truly aligned, the corporation will be focused on maximizing profits. The danger of having a split between ownership and management occurs when there is a lack of checks on management’s power and management is able to institute programs which benefit management independent of profit generation. Enron is a good example of this problem. Management was able to create all kinds of ways to pay managers bonuses or other payments, which had nothing to do with the actual generation of profits. Managers used all kinds of accounting tricks to make Enron appear profitable while cannibalizing the company. Finally, when the 2001 recession slowed the company’s cash flow, management could no longer paper over the problems and the company came tumbling down.

		April 28, 2007 *The Corporation: Profit Maximizer or Stakeholder Benefactor?*
	This is a response to a students question about the split between ownership and management of a corporation. I am not surprised that you feel confused about the separation of ownership and management in corporations, because this is a contentious area. I also teach economics. From an economic perspective, firms are most efficient when they maximize profits. This is because there are really only two legal ways to maximize profits: 1) reduce costs (create more with less), or 2) innovate (bring new products and services into existence that people want to buy). Since profits are the reward for ownership, in a corporation profit maximization benefits shareholders. Thus, a focus on benefiting shareholders by maximizing profits results in corporations that are constantly innovating and reducing the costs of production. This means faster growth and a higher standard of living for people in a country, which promotes such a system. There is an alternative view that you often hear which talks about stakeholder interests. "Corporations should exist to benefit stakeholders." The problem is that the word stakeholders turns out to mean almost everyone (owners, managers, employees, customers, the community, etc.) It sounds good, but benefiting stakeholders is like trying to achieve a goal when there is no clear goal. It is unfocused, and in my opinion becomes rather meaningless. Note, I mentioned that there are two legal ways to maximize profits. This is where law becomes essential. Corporations could try to maximize profits through theft, deception or through reducing costs by shifting the burden to others (e.g. pollution). Since the results of these strategies would be very damaging, we prohibit or restrict such strategies through law and steer corporations toward making profits in socially positive ways. One critique of my position might be that we want corporations who a good neighbors and who treat their employees well. We do not want greedy companies who think of nothing but the bottom line. The response is that profit maximization is compatible with such behavior. In order to legally maximize profits a corporation will find that it is important to have a positive reputation in the community. Thus, it will make charitable donations; keep its facilities clean, and take other steps to promote a positive image. It will also find that it must compete with other businesses to retain the best and brightest employees, who are capable of generating profits. A corporation cannot treat its employees poorly and expect to be profitable. It best employees with quickly jump ship and it reputation will make it incapable of hiring talented people. A profit maximizing corporation will also want to align the interests of employees and managers with the goal of maximizing profits for shareholders. Thus, it will have bonuses and other incentives to encourage managers to do so. As long as the interests of shareholders and managers are truly aligned, the corporation will be focused on maximizing profits. The danger of having a split between ownership and management occurs when there is a lack of checks on management’s power and management is able to institute programs which benefit management independent of profit generation. Enron is a good example of this problem. Management was able to create all kinds of ways to pay managers bonuses or other payments, which had nothing to do with the actual generation of profits. Managers used all kinds of accounting tricks to make Enron appear profitable while cannibalizing the company. Finally, when the 2001 recession slowed the company’s cash flow, management could no longer paper over the problems and the company came tumbling down.