The Purpose of the Ethical Firm

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This is the first article in a series on employee engagement, and how it is affected by the relationship between workers, managers, and shareholders.  Its all rather experimental, so your reactions are welcome.

Is the purpose of the firm to maximize shareholder value, or to maximize overall stakeholder value…or is it perhaps to create and serve customers?  There has been many debates over the years as to what the primary purpose of the firm is.

I define an ethical firm is one in which no-one is sacrificed or exploited to meet the firms’ or other stakeholder’s objectives.  I believe that this is a premise of most firms in a free market economy.

All of the current theories, I have come to believe through my Lean journey, are fundamentally flawed in that they miss the point.  Yes, firms need to satisfy the needs of providers of capital (you need money to make money!), and making customers happy might be a good strategy if you plan on selling things.  Firms also need to profit not at the expense of other things that the society as a whole values – for example the environment, obeying the law, and not harming others.  But surely these are the means to an end, and not the end in and of itself?

I’m a bit confused, because it seems rather simple to me.  How can a firm have any different a purpose than the collective purpose of the people who work there?  Do we really think people should work in firms just to make other people – such as the shareholders – rich?  No, of course not…and neither should we expect people to be motivated for the benefit any other stakeholder except themselves.

Individual Purpose

So why do people work in firms? Indeed, why did the first caveman leave the cave?  I’m guessing it was to find sustenance, gain happiness, be fulfilled, and make their world a better place to live in.  We can just call these things collectively ‘wealth’, though it is clearly more than money – it is perhaps an ‘absence of needs’.  Indeed – Maslov’s “Hierarchy of Needs” is a framework to capture the elements of such ‘wealth’.

Maslov’s Hierarchy of Needs

Maslov's Hierachy of Needs

Now we ask ourselves, why would someone join together with others to work?  Surely they would do so if they felt could gain more wealth collectively than working alone.  The same is surely true whether the firm is a two person or 200,000 person conglomerate.

Collective Purpose

If people work collectively in a firm for the purpose of maximizing their individual wealth creation, then the collective purpose of the firm is simply the sum of the wealth-creation aspirations of its workers.   From this simple and perhaps trivial analysis, firms should therefore exist simply to make their workers wealthier – and by ‘wealthier’ I really mean ‘happier and more fulfilled’, of course.  Keeping the environment clean, and creating a caring society, are also all things that might make people happy and fulfill their individual needs – so those also might be the collective purpose of the firm, if the firm was filled with people who cared about things like that.

The idea (that the purpose of the firm is simply the aggregate of the individual purposes of the people who are employed) can explain the multitude of purposes of public companies, private companies, not-for-profits, faith-based organizations, and voluntary organizations, in a way that I suggest other theories do not.

Moreover, from this concept, we can immediately understand how Vision, Mission and Value statements are more than just statements of ‘how we make money’, but speak directly to the collective purpose of the people who would choose to work at the company, and their ‘why‘.  How powerful is that?  I would argue very.  Vision and Mission statements wouldn’t necessarily need to be inspirational.  For perhaps a financial trading firm, “making lots of money for ourselves” could be quite appropriate -not particularly enlightened, perhaps – but perfectly appropriate (so long as it doesn’t result in a catastrophic collapse of the financial system…)

Competing Theories

Thinkers and writers far cleverer than I have proposed other theories of the purpose of the firm that are widely accepted.  Of these, the most prevalent are the Shareholder Theory (to maximize shareholder value), the Stakeholder Theory (to maximize multiple objectives from different stakeholders), and a customer-centric approach, that  has gained popularity recently.

I believe that it might be possible to take the various competing theories of the firm, and create a universal theory for an ethical firm (one which is not exploitative).  This theory would encompass the need to make a profit, to meet customer’s needs, and to fulfill worker’s lives.  I’ve had a go at creating such a model.  An interesting revelation is that this model appears to be built upon Lean principles.  Indeed, I believe that Lean is an ethical and moral system of corporate governance, and that therefore adopting Lean is as much a moral choice as an economic one.

A Universal Theory of the Ethical Purpose of the Firm

Purpose Hierarchy

Applying this in Practice

Why does this matter?  Well, what if we sat down and really asked ourselves “given that the purpose of our company is not to make (me) money, but to collectively make the lives of everyone who works here happy and fulfilled, what should we be doing differently to what we are doing today?”

I’m not talking about giving people bonuses, or time off or trivia like that, I’m talking about deeply tapping into the underlying motivations and needs that we all have as human beings.  Things like autonomy, mastery, purpose, the need for connection, and the need to make a difference.  How could you deliberately transform people’s jobs to make their life more meaningful?

Toyota, and Lean

Now it seems to me that Toyota asked just that question.  They realized that people have a lot to offer, want/need to be part of a group, to have control over their own work, and to have pride of workmanship.  They called this idea ‘respect for people’.  There is nothing new in these revelations – they are the basis of motivational theory.  However, their approach to it was new, and the system that evolved from this became known as Lean.  They did OK with it, I seem to recall, and the money certainly followed – but importantly they didn’t set out just to make money, and profit was never their main criteria – ‘doing the right thing’ was.

Toyota was aiming for something far greater than money.  They were improving the retched lives of their employees in post-war Japan.  A much more important and worthwhile goal than just making money, don’t you think?

Recap of Other Theories of the Firm

Shareholder Theory

The Shareholder theory states that generating profits and increasing shareholder wealth is the primary purpose of the firm, and that social and moral development should be left to the state.  Corporate philanthropy and any activity not directed at generating profits, is effectively stealing from the owners.  Mostly strongly espoused by Milton Friedman over four decades, the creed of maximizing Shareholder Value really took root during the Thatcher and Reagan era in the 1980’s, largely owing to jack Welch at GE giving a seminal speech in 1981.

This theory has given rise to two particularly nasty aspects of corporate behavior:

  1. Transaction Cost Economics (TCE), which focuses on the importance of corporate hierarchies to monitor self-interested behavior.  This has had the unfortunate affect of sanctioning opaqueness (the opposite of transparency) and disempowerment of employees within the hierarchy.  Because malfeasance is assumed, corporations have boards to monitor their executives.  Every body has a boss – even the CEO.
  2. Agency Theory which focuses on ways to align the interests of managers and owners, to bridge the ‘Principle-Agency’ gap.  This has, rather ironically, led to flagrant abuses of executive pay and short-term-ism, ultimately destroying long-term value – the very thing it was supposed to avoid.  In the period of shareholder capitalism since 1976, executive compensation has exploded while corporate performance has declined.

In the wake of the biggest financial collapse in history,  Jack Welch later recanted.  In 2009 he said in the Financial Times:

“On the face of it, shareholder value is the dumbest idea in the world.   Shareholder value is a result, not a strategy.  It is the product of your combined efforts – from the management to the employees.   Your main constituencies are your employees, your customers and your products. “- Jack Welch, FT March 12, 2009

In summary, therefore, maximizing shareholder value is poisonous for an organization attempting to become lean, or even agile, because it:

  • Demotivates workers because any extra effort goes to creating wealth for other people
  • Creates an environment of distrust and disempowerment

Given all this, it is no wonder that most employees are not engaged in their work!

Stakeholder Theory

The Stakeholder theory states that the purpose of the firm is to maximize benefits to all the diverse interests associated with a firm’s activities.  These range from employees, investors, customers, suppliers, and people that are affected by the activities of the firm in one way or another, including society at large.   The belief is that by serving the needs of other stakeholders, the firm will flourish, ultimately creating more value for its shareholders.

There are three major types of stakeholders:

  1. Capital market stakeholders, for example financiers and shareholders
  2. Product market stakeholders, for example customers, suppliers, communities
  3. Organizational stakeholders, for example employees

There are four major responsibilities of the firm, related to these stakeholders

  1. Economic, which is to generate shareholder wealth.
  2. Legal, which is to obey laws and regulations.
  3. Ethical, which is to recognize that the firm is part of a community, and thus has obligations to, and an impact on, others
  4. Discretionary, which is to engage in philanthropy

As we can see from this, the primary goal is still to generate shareholder wealth.  We cannot avoid the pitfalls of TCE and Agency, with all the problems that they bring.  Stakeholder theory adds little to the Lean imperative.

Customer Theory

Customer-centricity is the notion that the purpose of an organization is to create and serve customers.  It’s rise recently in popularity is partly based on the philosophies embedded in Lean Startup, and is at the heart of elements of Agile and Lean.  It is not, however, particularly new, and dates back almost as far as Shareholder Value.  Peter Drucker writes in 1973:

“There is only one valid definition of business purpose: to create a customer. . . . It is the customer who determines what a business is. It is the customer alone whose willingness to pay for a good or for a service converts economic resources into wealth, things into goods. . . . The customer is the foundation of a business and keeps it in existence.” – Peter Drucker, Management (1973)

 


Paul Osborn

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