Correcting a misunderstanding of the Friedman Doctrine

The Business Roundtable is a non-profit organization consisting of chief executive officers of major U.S. companies. For years they have advocated a shareholder theory of the corporation that places the interests of stockholders over the interests of other business stakeholders, such as employees or communities. Recently, the organization issued a statement that “Redefines the Purpose of a Corporation to Promote ‘An Economy That Serves All Americans’.” According to the organization, “Each of our stakeholders is essential.”

Many commentators hailed this change in language, some even going so far as saying it repudiates a position advocated by Milton Friedman nearly 50 years ago. For example, University of Chicago law professor Eric Posner, writing in The Atlantic, simply declared, “Milton Friedman was wrong.”

Portrait_of_Milton_FriedmanIn an essay published in 1970 in the New York Times Magazine, Friedman wrote that “the social responsibility of business is to increase its profits,” which has become known as the Friedman Doctrine. This is what Friedman said:

“In a free-enterprise, private property system, a corporate executive is an employee of the owners of the business. He has a direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.”

Unfortunately, both business executives and critics of Friedman misrepresent his argument, suggesting that he advocates maximizing profits at any cost. For example, in his Atlantic essay, Posner writes “Friedman argued that because the CEO is an ’employee’ of the shareholders, he or she must act in their interest, which is to give them the highest return possible.” It’s the period after the word “possible” that is problematic. Placing a period before the qualification Friedman added implies he does not support any constraints on the profit-making activities of businesses, which Friedman never did. Simply stated, it is not true that Friedman’s essay “seemed to absolve corporations of difficult moral choices and to protect them from public criticism as long as they made profits,” as Posner writes. In contrast, business executives must consider the moral choices of their decisions.

First, Friedman said it’s “generally” appropriate to make as much money as possible, not absolutely required. Second, he adds the necessity of “conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.” This second condition imposes considerable restraints on profit-making activities.

In an essay entitled “Smith, Friedman, and Self-interest in Ethical Society” published in the Business Ethics Quarterly, my colleague Farhad Rassekh and I complained about scholars and other writers who misrepresent Milton Friedman as well as Adam Smith. We wrote: “It is common in many business ethics textbooks to find Smith and Friedman interpreted as follows: People should pursue their self-interests; businesses should do whatever improves their financial position, even if others are harmed; and in some way the ‘invisible hand’ ultimately makes the effects of such actions right for society. Is this interpretation correct?” Our answer was a simple “no.”

Prior to publishing our paper, my co-author sent a draft of the paper to Friedman, who replied, “As you recognize, I have been very unhappy about some of the interpretations that have been placed on my position.”

After studying Friedman’s writings, Rassekh and I concluded the following:

“Although Friedman argues that business executives should focus on profit maximization, he does not condone all behaviors that increase financial returns. Quite explicitly, he places four restrictions on profit seeking: Business people must obey the law, follow ethical customs, commit no deception or fraud, and engage in open and free competition. The last restriction means political rent-seeking and anti-competitive behavior in any form must be avoided. For Friedman, social responsibility means pursuing one’s interests (such as making a profit) without adversely interfering with the freedom of others, so that everyone can freely enter into agreements ‘with their eyes open.'”

There are many things businesses have done in the interest of maximizing profits that Friedman would never have condoned because they violate ethical requirements or other conditions he places on businesses, such as mistreating workers, discharging harmful pollutants into the environment, withholding information about dangers created by their products, and abandoning communities in order to produce in lower-cost countries.

I wonder what would have happened if businesses in fact followed the Friedman Doctrine as Friedman actually declared it, and if commentators accurately represented Friedman’s position on the issue. I suspect the whole debate about stockholders versus stakeholders would have ended years ago and anything the Business Roundtable said today about the issue would have been a nonevent.

 

Unequal wages and claims of unfairness

A recent story on NPR, “2-Tiered Wages Under Fire: Workers Challenge Unequal Pay For Equal Work,” describes how workers at a US plumbing manufacturer responded after learning that some workers were paid differently than others for doing similar work. Simply stated, those paid less than their peers were not happy. According to the NPR story, “[One worker] says the unequal wages caused friction in the [company’s] distribution center, where newer, lower-paid workers grumbled at being asked to perform the same tasks for less money.”

Factory

After the “Great Recession” in the late 2000s, many companies changed their hiring practices, so that workers hired after the Recession were paid less than workers hired before the Recession. Even after the Recession ended, the two-tier wage structure persisted.

Is it fair that workers doing the same work receive different wages, even after controlling for time on the job?

Business executives might argue the situation or practice is fair. If workers agree to work at a wage of, say, $10 an hour, then how can they say that is not fair? Workers willingly accepted the terms of the contract. If they don’t like those terms, then they can work somewhere else. Besides, isn’t it better to be employed, even at a lower wage, than to be unemployed?

This is the challenge of dealing with issues of fairness. Fairness perceptions can be very subjective. What is perceived as fair to you might be seen as unfair to me. So, subjective assessments can be very difficult to assess. Which side is right? I guess it just depends on which side you look at. Assessing unfairness claims is also difficult when people adopt different conceptual or theoretical frameworks, such as principles of procedural or distributive justice or theories of John Rawls or Robert Nozick, because different perspectives weight elements of the problem differently (e.g., something is fair if the rules are followed, or something is fair if the outcome to everyone is the same, or something is fair if the size of the reward is commensurate to the effort expended, etc).

Asking which side is right misses the problem. Just because one person makes a good case that something is fair doesn’t mean that the other side’s perspective is without merit. Is there a way to assess objectively the merit of unfairness claims, such as those made by workers paid less than their peers?

Mary Hendrickson and I, along with our colleagues, have been working on this problem for a while. We have developed an innovative approach for assessing claims of unfairness that does not require the a priori selection of a specific theory or conceptual framework. Instead of picking our favorite theorist or theoretical perspective, we focus on the expectations that individuals have. Expectations are important because claims of unfairness usually arise when expectations are violated. For example, if my student expects an A in the class but receives a C, then it would not be surprising to me if she complains. Similarly, if I get pulled over for speeding and expect to get off with a warning but instead get a ticket, I might claim, “That’s not fair!”

In a series of papers (“Power, Fairness and Constrained Choice in Agricultural Markets: A Synthesizing Framework” and “The Assessment of Fairness in Agricultural Markets“), we show that evaluating the reasonableness of expectations is a way of assessing claims of unfairness, because reasonableness can often be evaluated objectively. If a person’s expectations are reasonable and if the expectations are violated, then the resulting claim of unfairness has merit. Conversely, if a person’s expectations are not reasonable, then any claim of unfairness resulting from a belief that expectations were violated would not have merit. For example, suppose an outside observer asked my student who received the C why she expected an A, and suppose she said, “because I worked hard and attended class every day.” Suppose further that the outside observer reviewed my course syllabus, which clearly stated that a grade of A is only awarded to students earning a score of 90 percent or higher on all tests (but makes no reference to “effort” or “attendance”), then the outside observer would likely conclude that the student’s expectations were not reasonable and hence the resulting claim of unfairness was without merit.

Several conditions can provide a reasonable basis for expectations. The first is equal treatment of equals. In our work we refer to this as “structural equivalence”. People who are structurally equivalent to others, that is, who are in the same position and doing the same work, would reasonably expect to be treated the same. The second is based on the idea of time consistency. For example, someone who has received a year-end bonus for many years would reasonably expect a year-end bonus this year. The third is rights, which by definition determine expectations. If I have a right to vote, then it is reasonable for me to expect to be allowed to do so. We discuss other ideas in our papers as well.

Are the complaints by workers in the plumbing manufacturer about the unfairness of wages with or without merit? Stated differently, is it reasonable for workers to expect to be paid the same as their peers for doing similar work given the length of time they worked in the company? I think this is reasonable. Why wouldn’t it be? If two workers are doing the same work for the same amount of time but one is paid more than the other, then the person receiving the relatively lower wage would have a claim that the wage structure is not fair.

Apparently the plumbing manufacturer agreed, too. A worker strike and a tight labor market brought labor and management to the bargaining table, with the company agreeing to phase out the two-tier wage structure within the next five years. According to the article, it was leverage that convinced the company to pay fair wages. Workers didn’t have leverage during the recession, but they have it now.

As great as leverage and other economic incentives are in moving businesses and people to fairer outcomes, it would be nice if instead they did that simply because it was the right, or fair, thing to do.

Corruption, 2018

Transparency International, the non-governmental organization responsible for the Corruption Perceptions Index (CPI), has released its new findings for 2018 (here). The CPI “ranks 180 countries and territories by their perceived levels of public sector corruption according to experts and businesspeople, [using] a scale of 0 to 100, where 0 is highly corrupt and 100 is very clean.”

2018_CPI_Globa_Map

The top three spots are held by Denmark, New Zealand, Finland, Singapore, Sweden and Switzerland (there are ties at position #3). Compared to 2017, Denmark and New Zealand swapped places, while Singapore and Sweden bumped Norway out of the top three. Denmark’s score remained the same while New Zealand’s fell by 2 points.

The United States was ranked #16 in 2017, but it dropped to #22 in 2018, losing 4 points off its CPI score. Its score of 71 is the lowest since 2012; neighbors on the list are France, United Arab Emirates and Uruguay.

We often focus on countries at the bottom of the CPI, such as Sudan, North Korea, Yemen, South Sudan, Syria and Somalia. These countries deserve attention. Corruption in those countries is compounded by violence and political unrest.

But countries at the top of the CPI are not perfectly clean, either. An analysis by Transparency International, entitled “Trouble at the Top: Why High-scoring Countries Aren’t Corruption-Free,” describes cases of money-laundering, bribery and other cases of public and private malfeasance. The problem is that these countries are home to large multinational corporations that export many goods and service, and that “most of these countries are failing to investigate and punish companies when they are implicated in paying bribes overseas.”

It’s important that we promote transparency, rule of law, democratic processes and leaders of integrity. But it’s probably more important that we care. Vice thrives in an environment of indifference and distraction. Caring means we pay attention to reports of corruption and what goes on in the world, including our own backyards. Less important is what’s the latest show to binge watch on Netflix or what’s happening in our Facebook feed.

In defense of the morality of capitalism

I am tired of capitalism being misrepresented by politicians, academics and other commentators. Both proponents and critics of capitalism are to blame.

Proponents typically argue that if the government gets out of the way and if people are free to own property and pursue their own interests, everything will be fine. Generalized statements such as this demonstrate virtually no understanding of what capitalism is and how and why it works.

Critics point to problems (e.g., market cycles, corporate scandals, income inequality, etc) as evidence that capitalism is not working and cannot work. Is the fact that the profits of some companies are so high (Apple made $48 billion, Verizon and AT&T about $30 billion each, and Wells Fargo $22 billion in 2018, according to Fortune) an indication that capitalism is functioning as intended, or not?

Several years ago my wife brought home a book from the library for me to read by an academic who proposed ideas on how to solve many of the economic problems we are observing in society. In the introduction the author noted that “standard textbook economics” supports the view that an unregulated capitalistic system consisting of private enterprise will solve all of our problems. Frankly, I am not familiar with any contemporary economic textbook that makes such as claim, and if there is one the author (presumably an academic) should immediately be stripped of tenure. I didn’t finish the book.

adam-smith-9486480-1-402The crucial element of capitalism that is missing by proponents and critics alike is the role of self-restraint, public virtue and justice. Capitalism cannot persist without a people that is willing to exercise some self-control in their personal, economic and public behavior. Even the “father” of modern capitalism, Adam Smith, recognized this. He wrote Theory of Moral Sentiments before Wealth of Nations. Moral sentiments are the foundation, not a by-product, of capitalism. There is a plethora of modern scholarship supporting this view of Smith. Unfortunately, our policymakers, and even many academics, do not keep up with the academic literature.

Justice is the pillar that holds up capitalism. Justice requires both a just people and just institutions. Many, if not most, of the problems we are experiencing in economic society occur because people are excessively selfish. Period. Where is the other-regarding behavior necessary for capitalism to survive? While self-interest is a central aspect of Smith’s economic system (capitalism), selfishness is not.

But the line between self-interest and selfishness is thin. Both Smith and Darwin noted that altruism does not necessarily give individuals a selective advantage, but groups made of up altruistic individuals will. In his 1871 book, The Descent of Man, Darwin said that a group that has members “possessing in a high degree the spirit of patriotism, fidelity, obedience, courage, and sympathy, [who] were always ready to aid one another, and to sacrifice themselves for the common good” would out-compete selfish groups. I can’t believe I’m writing this, but Darwin is correct. So everyone else practice public virtue while I lie, cheat and steal. And that is the rub. Since other people will have this same thought, public virtue and moral behavior decline. Another example of the Prisoner’s Dilemma. This is the root cause of our economic failings.

Capitalism is not the problem. The problem is people who believe that anything they do to enrich themselves will be good for society. Adam Smith’s “invisible hand” does not work this way. If we can’t live with an invisible hand, then someone, or something, else’s iron hand will become all too visible. Note the connection with the foundation of a Constitutional republic. Quoting John Adams: “Our Constitution was made only for a moral and religious people.” And Benjamin Franklin: “Only a virtuous people are capable of freedom. As nations become corrupt and vicious, they have more need of masters.”

If we lose capitalism in our selfish pursuits, then are we really willing to accept what must come in its place?

Should voluntary actions to improve water quality require a regulatory nudge?

Missouri_River_near_Hermann_9-1990

Water quality is a huge problem in many parts of the world. People and animals need clean and uncontaminated water to live. But people also work in and live near enterprises that can create serious risks of contamination, so balancing our interests in producing with our interests in drinking safe water can be a challenge. For example, factories can discharge pollutants and chemicals into waterways, or they might incorrectly store waste resulting in eventual leaching into waterways and underground aquifers. Farms use fertilizers or other chemical inputs that drain into rivers and streams. Ranches and concentrated animal feeding operations produce a lot of animal manure that can contaminate water sources. How do we address these issues in a way that is fair to all stakeholders?

One way of doing this is educating relevant stakeholders and encouraging them to take voluntary actions to reduce their share of contaminants reaching water sources. An example is the Nutrient Reduction Strategy. This is an effort by 12 states, whose farms and businesses contribute to the problem of hypoxia in the Gulf of Mexico, to reduce contamination of the Mississippi/Atchafalaya River Basin (MARB). The US Environmental Protection Agency (EPA) coordinates the effort and encourages states to develop their own strategies “for implementing and developing load reductions,” according to the EPA’s website on the topic (here). This website also links to each state’s strategies and reports on their progress.

Important here is that the EPA “calls” for states to develop and implement nutrient reduction strategies, but it doesn’t require them to do so. In effect, this creates a classic prisoner’s dilemma. While all states recognize the importance of reducing contamination of the Mississippi River, the ideal is for 11 states to do this aggressively while the 12th state does it slowly, since regulations can be costly and unpopular. But if all states face this incentive, then the push for states to get the job done is weakened. So, sometimes a regulatory or legal nudge is needed to move all states to a cooperative outcome.

One way of doing this is to bring a lawsuit against a state that does not seem to be making the progress that one thinks it might otherwise have completed. This recently happened in Iowa. According to a Feedstuffs article, “Groups sue Iowa over water runoff. Suit alleges state of Iowa is failing to protect its waterways from farms.” The lawsuit states the following, as reported in the Feedstuffs article:

“The most recent ‘Iowa Nutrient Reduction Strategy Progress Report’ was released on March 7, 2019. The report acknowledges that adoption of the strategy’s agricultural best management practices was not making sufficient progress towards its nonpoint-source nutrient reduction goal. While annual progress continues in the implementation of these practices, early [Nutrient Reduction Strategy] efforts only scratch the surface of what is needed across the state to meet the nonpoint-source nutrient reduction. Progress has occurred, but not at the scale that would impact statewide water quality measures. Local water quality improvements may be realized in the short term where higher densities of conservation practices are in use, but the ability to detect early trends in measured water quality will vary from case to case. Statewide improvements affected by conservation practices will require a much greater degree of implementation than has occurred so far.”

However, lawsuits can be a double-edged sword. On the one hand, if successful they can push state legislatures to be more proactive in promulgating laws to reduce point and non-point water pollution. On the other hand, defending against lawsuits diverts government attention away from the very thing the lawsuit stresses. According to one farmer quoted in another news report of the Iowa lawsuit (here), “At a time when farmers are struggling financially from low commodity prices and also now from historic flooding, this lawsuit is a low blow. It will divert the state’s financial resources from implementing soil and water conservation practices, and also divert resources away from helping our farmers recover from the latest natural disaster.”

The ideal, of course, is for all of us to recognize the responsibilities we have to be mindful of the environment and our role in contaminating it. Stewardship is a good word here. Those who intensively use natural resources have a particular responsibility to be wise stewards over those resources and to be cognizant of how their actions affect others. Solving the prisoners dilemma is possible without formal laws and regulations, but it requires that everyone cooperative and share the burden.

What does it mean when corporations are as economically powerful as governments?

In 2016, a non-governmental organization by the name of Global Justice Now, based out of the UK, produced a report listing the largest governments and corporations by revenue. Their report stated that the “10 biggest corporations make more money than most countries in the world combined and that 69 of top 100 economic entities are corporations not countries.” The complete listing of governments and corporations is here.

An article in the Journal of Economic Perspectives by Luigi Zingales of the University of Chicago provides the following commentary about corporations that rival the size of governments:

In some cases, these large corporations had private security forces that rivaled the best secret services, public relations offices that dwarfed a US presidential campaign headquarters, more lawyers than the US Justice Department, and enough money to capture (through campaign donations, lobbying, and even explicit bribes) a majority of the elected representatives. The only powers these large corporations missed were the power to wage war and the legal power of detaining people, although their political influence was sufficiently large that many would argue that, at least in certain settings, large corporations can exercise those powers by proxy.

The 2015 list produced by Global Justice Now consisted of 26 governments and 24 corporations in the top 50. Walmart was number 10, ahead of Spain, Australia and the Netherlands. I’ve updated the list for 2016 (see below). Walmart is now number 9 on the list, and there are 26 corporations in the top 50 in terms of revenue.

What does it mean when corporations are as large and economically powerful as governments? Is this a good thing? Governments can coerce people, while companies grow by persuading people to buy their products, unless businesses use their economic power and resulting political influence to suppress competition—a common practice in both the developed and developing world. But are governments a more effective and appropriate steward over the vast wealth they control than corporations? Politicians and government bureaucrats are not likely more altruistic or caring of people than business executives and managers. (This reminds me of an excellent interchange between the late Milton Friedman, a Nobel Prize winning economist and academic at the University of Chicago, and talk show host Phil Donahue about the relative greed of people in business and government, here). Perhaps the more important question is whether appropriate checks and balances remain between business and government when businesses rival the size and economic power of governments. I don’t know. I’m just asking questions.

Here is the ranking of governments and corporations by revenue in 2016. Data on government revenue (not GDP) from the CIA World Factbook for 2016 and on business revenue from the Fortune Global 500 list.

Rank Type Name Revenue, $billion
1 Government United States 3,363.0
2 Government China 2,300.0
3 Government Japan 1,696.0
4 Government Germany 1,523.0
5 Government France 1,308.0
6 Government United Kingdom 996.3
7 Government Italy 842.5
8 Government Canada 594.7
9 Corporation Walmart (US) 485.9
10 Government Spain 461.3
11 Government Australia 420.5
12 Government Netherlands 340.8
13 Corporation State Grid (China) 315.2
14 Government Brazil 311.9
15 Government South Korea 297.3
16 Government India 273.3
17 Corporation Sinopec Group (China) 267.5
18 Corporation China National Petroleum (China) 262.6
19 Corporation Toyota (Japan) 254.7
20 Government Sweden 248.3
21 Corporation Volkswagen Group (Germany) 240.3
22 Corporation Royal Dutch Shell (Netherlands) 240.0
23 Government Belgium 232.3
24 Government Mexico 224.3
25 Corporation Berkshire Hathaway (US) 223.6
26 Government Switzerland 215.9
27 Corporation Apple (US) 215.6
28 Corporation Exxon Mobil (US) 205.0
29 Government Norway 199.8
30 Corporation McKesson (US) 198.5
31 Government Austria 187.3
32 Corporation BP (UK) 186.6
33 Government Russia 186.5
34 Corporation United Health (US) 184.8
35 Corporation CVS Health (US) 177.5
36 Corporation Samsung Electronics (South Korea) 174.0
37 Corporation Glencore (Switzerland) 173.9
38 Corporation Daimler (Germany) 169.5
39 Corporation General Motors (US) 166.4
40 Corporation AT&T (US) 163.8
41 Government Denmark 156.9
42 Corporation Exor (Italy) 154.9
43 Corporation Ford Motor (US) 151.8
44 Government Saudi Arabia 149.7
45 Corporation Industrial & Commercial Bank of China (China) 147.7
46 Government Turkey 146.4
47 Corporation AXA (France) 143.7
48 Corporation Amazon (US) 136.0
49 Corporation Foxconn (Taiwan) 135.1
50 Corporation China Construction Bank (China) 135.0

Economic principles and healthcare reform

On Thursday, May 4, 2017, the US House of Representatives passed a bill repealing major aspects of President Obama’s healthcare law (Obamacare), as reported (here) in the Wall Street Journal and other news outlets. The bill goes to the Senate for a vote. The bill ends mandates for people to carry health insurance and for companies to offer specific types of health coverage, among other things. Another Wall Street Journal article (here) states that backers of the bill “are betting that these changes will engender competition, draw healthier people into the insurance pool and cut premium prices overall.” Interesting, this is the same justification that backers of Obamacare gave when it was passed in 2010.

I know a thing or two about economics. There is nothing in economic theory or experience to suggest that anything in the old or new laws will necessarily increase competition or lower costs. Competition exists when there are many buyers and sellers in the market, where it is relatively easy for buyers and sellers to enter or exit the market, and where “all” sellers sell products or services that are similar enough so that it is relatively easy for buyers to comparison-shop for the best product at the best price. In this system, sellers have incentives to lower costs and prices and to increase quality in order to attract customers to their products. Companies that do this well are rewarded with profits; companies that don’t do this well go bankrupt. The incentive to lower costs and prices and to increase quality diminishes when it is difficult for buyers to compare products and services — that is, when it is costly for consumers to shop around, and when companies know it is costly for consumers to shop around — and when it is difficult for potential sellers to enter markets — that is, when there are barriers to market entry. The health care system is rife with problems of comparison shopping and market barriers. That is, the health care system is not a great model of markets and competition, and it won’t be anytime soon.

The root cause of the problem with contemporary health care is the thing Americans like most about it. We pay a monthly fee for health insurance. Then when we get sick or need health care services, we might pay a nominal fee (e.g., $20) in return for health services, while most of the cost of care is paid by insurance companies whose revenue comes from the thousands of patrons paying the monthly fee. Once we have health insurance, we have no incentive to shop for the best healthcare product at the best price, but rather the best healthcare product at any price, because the primary cost of service is paid by the insurance company. The insurance company does not have a strong incentive to induce health care providers to lower costs because the company can pass costs on to patrons.

Even when individuals want to know the cost of a particular medical procedure or service, it is nearly impossible for them to get a straight answer. “How much will the physical therapy cost?” I once asked a clerk at the reception desk? “I don’t know. It depends on the contract your insurance company has with us,” was the reply. “What is your normal rate, and what discount does my insurance company offer on that rate?” I asked. “I don’t know what our main charge is. Your discount will depend on your co-pay and co-insurance.” The conversation never got any better. Only after I got the bill did I learn what the cost of the service was.

Transparency in pricing for medical care will help here. Giving individuals an incentive to price-comparison shop will help, too. Health savings accounts can do this. Recently I have been scrutinizing our health insurance bills because we have a health savings account. It’s time consuming because there are so many individual charges, most of which I do no understand. In one instance we received a bill for a doctor’s visit on a day we could prove no one in our family was at the clinic. If I was not paying out of a health savings account I would not have thought twice about questioning the bill. The insurance company would have paid it. But I did question the charge and was able to get it removed.

I understand the health care system is very complex. But economic principles are not.