Behavioral Economics uses psychology, neuroscience, and economics to examine how humans make economic decisions. It includes the process of studying the biases, rules of thumb, inaccurate or incomplete information, propaganda, and other influences that interfere with our making optimal decisions. It also presents prescriptions for countering these irrational influences in order to make better decisions as employees, citizens, and family members.
To begin to understand this field, we should look at one of the most pervasive and consequential biases that has affected our entire economy: the oft-repeated belief that a company’s purpose is to “maximize its profits” and to only look out for the owners’ and shareholders’ interests. This idea has roots in the writing of economist and Nobel Prize Laureate Milton Friedman. In an article in The New Times Magazine, Friedman stated,
…there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profts so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud (1970).
The University of Chicago Department of Economics, where Friedman taught, was (and still is) the center of conservative free-market economics in the United States. His general argument was that any employee of a business or corporation is an agent of the owner or its stockholders and has no right to spend their money in any way other than to increase profits. The owners and stockholders can then do anything they want with their profits, including spending it on some “social purposes.” Whether because of simple greed or true capitalist philosophy, this became a battle cry of capitalists and was widely quoted and used in corporate mission statements. It also was used in management and finance textbooks as a fundamental guiding principle and turned up in corporate annual reports as a mission statement to “maximize shareholder value.” The problem with Friedman’s entire theory is that it is simply wrong. Since this is a text about financial literacy, I will not spend a long time discussing the Friedman’s errors. However, I will make three points:
- Corporations and partnerships must apply to a state to receive the permission to incorporate. This is not a right but a privilege. For example, according to Pennsylvania state laws, the state grants the right to incorporate for the “good of the Commonwealth.”
- Freidman’s view was not the majority view when he voiced it. In the mid-twentieth century, firms were an integral part of their communities and the prevailing view was that firms had a responsibility to their shareholders, employees, and communities (Wells, 2020).
- The “free market competition” that Friedman envisioned in his theory does not exist in most markets, It is a fiction made up by economists.
Perhaps the most telling repudiation of Friedman’s theories is that recently the CEOs of most of the largest corporations stated definitively in what can only be called a manifesto that the purpose of a corporation is not what Freidman said it was, but that corporations do have a social responsibility. The press release for this new manifesto was promulgated by the 181 CEO members of The Business Roundtable on August 20, 2019, which stated,
Since 1978, Business Roundtable has periodically issued Principles of Corporate Governance. Each version of the document issued since 1997 has endorsed principles of shareholder primacy – that corporations exist principally to serve shareholders. With today’s announcement, the new Statement supersedes previous statements and outlines a modern standard for corporate responsibility…we share a fundamental commitment to all of our stakeholders…. Each of our stakeholders is essential. We commit to delivering value to all of them, for the future success of our companies, our communities, and our country (2019).
It is my sincere hope that this new philosophy will become the best practice in business. However, as of this writing, this pledge is over three years old, and according to the empirical evidence, this has not been the case (Colvin, 2021).
Dennis A. Muilenburg, Chairman, President, and CEO of The Boeing Company, signed the pledge. A recent Congressional investigation on two Boeing 737 MAX airplane crashes (which had been grounded by the Federal Aviation Administration due to safety issues) casts doubt on his commitment. John Cassidy, an economics reporter for The New Yorker, summarized some of the reports’ key findings:
It illustrates how Boeing’s management prioritized the company’s profitability and stock price over everything else, including passenger safety. Perhaps even more alarmingly, the report shows how the F.A.A., which once had a sterling reputation for independence and integrity, acted as a virtual agent for the company it was supposed to be overseeing (Cassidy, 2020).
This is known as a “regulatory capture”—when a company dominates the regulator that is supposed to be overseeing it.
In 2020, KKR Advisors and TCP published a more comprehensive analysis of corporate responsibility, reviewing all 500 companies in the S&P 500 and all 300 companies in the European FTSEurofrst Index. They were able to compile extensive data on 619 of these 800 companies and use a machine learning high-tech lab to analyze millions of data points. The report reached these key conclusions:
- Business Round Table’s (“BRT”) Signatories’ “Purpose-Washing” Unmasked: Since the pandemic’s inception, BRT Signatories did not outperform their S&P 500 or European company counterparts on this test of corporate purpose.
- Powered by Purpose: Companies with long track records of strong performance outperformed more than expected, while laggards’ underperformance became more pronounced, demonstrating how resilient companies were further fortified during this corporate purpose stress test.
- Speed matters: Proactive, substantive responses to the pandemic and inequality crises had a discernible positive impact. Slow responders underperformed.
- Global challenges: U.S. and European companies performed roughly the same on this test of corporate purpose.
- Shareholder capitalism is no longer ft for purpose: TCP highlights the business case for ushering in a new form of stakeholder-aligned capitalism (Cassidy,2020).
There are some positive changes underway in the corporate world.
- The Pandemic Recession and the resultant labor shortage have increased wages, benefits, and working conditions for workers in the U.S.
- Shareholder and popular activism has prompted corporations to promote their “green” efforts.
These changes, while welcome, do not seem to be a result of the BRT’s new manifesto of the Principles of Corporate Governance. Rather, they seem to be the result of market forces and political pressure.