From the President: Profit-maximizing Firms Generate Social Impact Too

Monday, November 28, 2016

In a perspective article, WDI President Paul Clyde observes the trend of top business schools establishing institutes and programs designed to help develop businesses that make money and simultaneously provide benefits to society. While Clyde sees merit in the educational endeavor and the business practice, he also believes we must be careful not to undermine the societal impact of for-proft businesses.

As the William Davidson Institute at the University of Michigan (WDI) nears its 25th anniversary next year, I have been looking at how business schools approach development in low- and middle-income countries and noticed an increase in the institutes and programs designed to help develop businesses that make money and simultaneously provide benefits to society at large. Examples include the Social Enterprise Initiative at University of Chicago’s Booth School, the Center for the Advancement of Social Entrepreneurship at Duke’s Fuqua Center, Social Enterprise at Goizueta (Emory University), The Center for Responsible Business at The University of California’s Haas School, and The Social Enterprise Initiative at Harvard.  I would also include WDI on this growing list, though social enterprise was not WDI’s focus when it was established in 1992. Of U.S. News and World Report’s top 20 business schools, well over half have some sort of social institute that does work in low- and middle-income countries around the world.  Others have created social institutes focused on the United States.

Paul Clyde, right, teaching at the University of Michigan's Ross School.

This proliferation of socially oriented institutes within business schools suggests that the business education community sees social enterprise, broadly defined, as an important mechanism for creating change, and perhaps even something that the traditional business subject – for-profit businesses – cannot do. Oxford University’s Skoll Centre for Social Entrepreneurship appears to say just that:

We believe socially entrepreneurial approaches have much to contribute in creating this new market; for rather than pursuing activities that seek to maximise profits at society’s expense, these entrepreneurs put principles ahead of profits for society’s benefit.[1]

This is misleading at least and harmful at worst.

Socially oriented institutes pursue goals that most would agree are worthy – poverty alleviation, environmental sustainability, health provision for the poor, to name a few. It is certainly true that business practices and skills can be used to the benefit of any organization. However, in our zeal within the business education community to pursue these admirable social goals, we risk losing sight of the most powerful mechanisms for affecting economic change: for-profit businesses.

For-profit businesses generate social benefits too. As Adam Smith taught us 240 years ago from a school just a bit north of Oxford, businesses generate these social benefits not because making the world better off is explicitly part of the intention of producers – but because, with a few important exceptions noted below, the pursuit of profits benefits society as a whole. Some of this value accrues to the consumer in the form of “consumer surplus” – the difference between what the consumer pays and the maximum amount the consumer would be willing to pay for the product or service. Some of the value accrues to the producer in the form of “producer surplus”—the difference between what the producer is paid and the lowest amount that the producer would need to receive in order to participate in the transaction. Notably, the value going to producers can—and generally does—get shared with multiple participants on the producer side, including not only investors (debt and equity holders), but also employees and suppliers.

At first blush, this might seem less beneficial than an organization that is deliberately focused on social goals such as poverty alleviation. Such a view, however, misses a major benefit of profit-maximizing ventures. Any company will be attracted to opportunities to increase profits. Companies that identify profit enhancing opportunities will increase their scale, while other companies will jump into the marketplace to compete for the profit opportunities. Both actions lead to growth in output, employment and welfare. Companies with social goals, in addition to or instead of profits, will not have the same impact on their own behavior or on that of others.

Note that a bright line is drawn here between profit-maximizing activities and all other activities, including firms that pursue multiple goals, one of which is profits. This includes social entrepreneurs, organizations pursuing so-called shared value, corporate social responsibility, triple bottom line and myriad other terms, all of which involve a tradeoff of profits for some other goal. For some of these organizations, profits are among the goals, but they are not the only goal. Pursuing another goal in addition to profits requires the possibility of sacrificing some of the potential return on an investment. Such a compromise on the return is, in essence, a subsidy and should be recognized as such. As a result, all things being equal, companies with social goals, in addition to or instead of profits, will not have the same impact on their own behavior or on that of others.

None of this is to say that there isn’t a place for social enterprises. There are some customers who will not be served by purely for-profit activities. An inability to pay can perhaps best be addressed by government provision or by an NGO that doesn’t seek to maximize profits. For example, many services and products within education and healthcare may only be provided by an organization willing to sacrifice some or all of its profits. In these cases, there is a good argument for a social enterprise, and business principles can be applied here just as they are in for-profit enterprises.

However, even in these cases, we must be careful not to undermine profitable activities that, because of the subsidized activities, cease to be provided or are not provided in the first place. It has long been recognized and taught in microeconomic classes that subsidizing products in a low-income economy has a debilitating effect on local businesses trying to produce that product themselves. The classic example of this is agriculture where U.S. policies have often resulted in artificially high prices in the U.S. and thus more output than U.S. consumers are willing to buy. This leads to a problem: the producers (the group the policy was designed to help) can’t sell everything they produce. One solution to dealing with the surplus is foreign aid: the overproduction in the U.S. can be purchased by the U.S. government and then given away to other countries. However, this aid can completely undermine local farmers in the foreign country. I recall teaching this principle one semester in one of my classes and watching a student in the front row become increasingly agitated. She finally spoke up and explained that her family was one of those farmers in a Latin American economy and they had suffered the consequences of this “aid” from the United States. If the tables were turned, and a Latin American firm had tried to offer “aid” to the U.S., the Latin American firm would likely be charged with dumping by the U.S. government.

The risk of undermining the local economy isn’t limited to products. The doctor who flies in to perform surgeries for free is great for those who receive the surgery, but that doctor may unintentionally undermine the ability of the local hospital to charge a price for the same surgery. In doing so, the free surgeon may be putting an institution that provides more complete and continuous healthcare to the community at risk of financial collapse.

In contrast, local businesses that develop models that work in these economies lead to permanent changes in the welfare of a community. Such companies provide a return for investors, jobs for local labor and ready buyers for local suppliers.

Institutes at business schools, including ours, need to keep this in mind when offering programs or developing products to “help” a local community. In general, activities that do not result in continuing subsidies may be less likely to have these harmful effects. For example, assisting in starting up, developing viable business models or providing education might be expected to distort the local economy the least and have a net positive impact. But we should still be very careful. Anything that leads to long-term involvement at a subsidized cost could have a negative net effect.

It is also true that businesses can be harmful. A recent film titled “When Elephants Fight” documents the role of companies in perpetuating the conflicts, rapes and murders that have plagued the Democratic Republic of Congo (DRC) for decades. The companies may not have started the conflict and it may continue without them, but they are participating in transactions of minerals that enable and even encourage this behavior; and they are having a downright evil impact. Humans run businesses. Humans can be evil and so can the businesses that they run. Some of the companies operating in the DRC are an extreme example of the larger category of externalities. Externalities arise when the costs or benefits to a business under or over-state the social costs or benefits.  When this happens, the decisions by the business will not coincide with those that are in the interest of society.  In such cases, there is a role for governments and/or NGOs.

Thus, my point isn’t that for-profit firms are necessarily going to produce social benefits. Sometimes they don’t. Nor is the point that there is no place for social enterprises that have multiple goals. Significant externalities or instances in which, due to poverty, basic needs cannot be met are some of the common examples in which social enterprises or government involvement may be the only options.  Nor is this article a condemnation of the institutes at business schools previously referenced. As noted at the beginning of this essay, WDI was initially established to work with the for-profit firms transitioning from communist to free market economies in eastern Europe and the former Soviet Union; however, over the years the Institute has also worked with social ventures of various sorts.

The point is that we may have overplayed the hand of social enterprises and, in the process, lost sight of the potential power of the for-profit enterprise.  An organization that pursues a social mission isn’t necessarily socially beneficial and a for-profit business isn’t necessarily socially costly.  In the vast majority of cases, purely for-profit businesses provide significant value to economies. Indeed, it is hard to imagine how an economy is going to develop without them.  As educators and advisors we must constantly keep this in mind.

[1] Skoll Centre for Social Entrepreneurship, as accessed on October 12, 2016. The site removed this language, which still exists on an Oxford affiliated site here.

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