The Rights and Wrongs of Milton Friedman
Milton Friedman’s infamous article, “The Social Responsibility of Business is to Increase its Profits”, is widely ridiculed for exemplifying everything that’s wrong with capitalism. But many of Friedman’s critics haven’t read further than the title. They think they don’t need to, since the title already makes his stance clear: companies should maximize profits by extorting customers, slave-driving workers, and polluting the environment.
Yet Friedman never advocated this. On the contrary, he stressed that it’s good for society, not just shareholders, if a company focuses on profits, because the only way a company can make profits – at least in the long term – is if it invests in its stakeholders. He wrote that “it may well be in the long-run interest of a corporation that is a major employer in a small community to devote resources to providing amenities to that community or to improving its government. That may make it easier to attract desirable employees.”
Indeed, many scandals caused by companies exploiting stakeholders – such as Wells Fargo’s fake bank accounts and Volkswagen’s defeat devices – may have been the result of too little, rather than too much, focus on shareholder value. Their CEOs clearly didn’t maximise shareholder value, since the fallouts substantially damaged long-term profitability.
But as I explain in Chapter 2 of the book, and a recent blog post for Chicago Booth entitled “What Stakeholder Capitalism Can Learn From Milton Friedman”, Friedman’s argument rests on a number of assumptions. The most critical one is that CEOs can calculate the impact that an investment has on future profits. Calculation indeed works for tangible investments with measurable outcomes. When contemplating a new factory, a CEO can forecast how many widgets it will produce and how much it can sell them for, and compare this to the cost.
However, calculation typically fails for intangible investments, such as whether to give employees paid family leave. The costs are relatively easy to calculate. But the benefits are much harder. The policy will allow the company to hire high-quality women who’d otherwise be excluded, but it’s hard to estimate how much the firm’s talent pool will improve by, and how this will boost profits. Not only will the women be valuable in their own right, but also contribute to a diversity of thinking – but again this is impossible to estimate. So you can’t calculate the NPV of parental leave, and without it, you can’t justify such a policy.
This is my main argument for responsible business. A company should have explicit social objectives and care about stakeholders for intrinsic reasons (investing in them is the right thing to do) rather than instrumental reasons (it can calculate an impact on long-term profits). Freeing itself from the need to justify every decision based on its profit impact will lead to it making more investments, and ironically end up generating more profit than if it were pursued directly.
But where’s the evidence? In a new paper, Ben Bennett, Isil Erel, Lea Stern, and Zexi Wang study the adoption of Paid Family Leave (PFL) laws in the U.S. between 2002 and 2018. This requires firms to give their employees paid leave for a family or medical event. Prior research showed that this increased female workforce participation, but what’s the effect on profits? The authors use the fact that PFL laws were enacted by different states at different times to identify causation rather than just correlation. Finding that firm productivity went up after a law was passed doesn’t tell us much, as it might be that the law was passed just before an economic upswing, and it was that upswing, not the law, that improved productivity.
So the authors compare the productivity of firms in counties next to a state border with adjacent counties on the other side of the border. The idea is that economic conditions will be very similar in adjacent counties, but one state passed the law and the other didn’t. The authors find that productivity improves by 4% in the state that passed the PFL law, relative to the adjacent state. They do further tests to identify the channels behind the productivity gain – employee turnover is lower, and the number of female top executives is higher.
The results are striking. If Friedman were right, and managers could instrumentally calculate the effect of PFL on future profits, they’d have offered it themselves anyway. There’d be no need for a law. Indeed, laws could only backfire, as they might lead to companies having to offer PFL even if, for them, the costs outweigh the benefits. But the fact that the law improved productivity suggested that some CEOs didn’t understand the business case for PFL. Other studies covered in Chapter 4 the book provide evidence that investors under-estimate the relevance of employee satisfaction, customer satisfaction, eco-efficiency, sustainability policies, and performance on material stakeholder issues.
Mandated Parental Leave vs. Mandated Board Diversity
How do the results square with laws to increase board diversity, such as the Norwegian and recent Californian board quotas? The evidence for diversity is widely misportrayed, in part due to confirmation bias, and in fact the rigorous academic evidence shows that diversity has no effect (positive or negative) on firm performance, and board quotas reduce firm performance, both in Norway and California.
However, these laws are rather different from PFL. PFL reduces labour market frictions that arise because women disproportionately bear the consequences of having children compared to men. PFL thus allows men and women to participate more equally in the labour force. It doesn’t force companies to hire less-suited women over more-suited men, but allows women who are at least as qualified as men to apply who wouldn’t have done otherwise. In contrast, quotas create market frictions, as they may force a company to appoint a less-suited director to fill a quota, or lead to female directors being “overboarded” – appointed to many board seats to fill quotas, thus spreading them too thinly.
As stressed in Chapter 10 of the book, regulation certainly has a role to play in reforming business to serve wider society. However, regulation should be permissive rather than prescriptive, removing market frictions rather than introducing them. Just like most things in business, regulation is neither universally good nor universally bad. Poorly designed it can backfire, but thoughtfully implemented it can grow the pie.