Milton Friedman was not a rational actor

The rational-actor paradigm came to dominate social sciences such as economics in the mid-20th century. It assumes that people are selfish and try to rationally maximize their self-interest without regard for the effects on people around them. Critics sometimes call it the rat-actor paradigm, but that name really isn’t fair to rats who are often much more altruistic than the rat-actor paradigm assumes. The main reason why the rat-actor paradigm was successful at taking over economic thinking was that it is so simple and that made economic modelling easier to do. Simplicity was particularly important for mathematical modelling which came to dominate thinking in economics during this time because complexity is much harder to model with mathematical equations. And everyone has selfish impulses at times, so the rational actor paradigm sometimes does an OK good job predicting human behavior.

But the behavioral revolution in economics has been growing in influence over the past several decades by demonstrating that people are neither purely selfish nor rational.  We are predictably altruistic and irrational. For example, most people wouldn’t kill their parents for money even if they thought nobody could find out.  Lots of Americans could inherit more money sooner by killing their parents, but it seems to be a very rare phenomenon.

Duff McDonald wrote a book called The Golden Passport about “the Moral Failure of the MBA Elite” at Harvard Business school. McDonald wrote that because of adopting Friedman’s ideology, Harvard Business School changed from an place that emphasized the character of its MBA graduates into a place where professors focused on selfishness, and the Principle-agent theory which assumed that employees should maximize shareholder value:

The term Principle-agent theory was coined in the early 1970s and it suited Friedman’s idea that the owners of capital are principles whose agents (labor) should seek to benefit [the principles].

In a 1994 paper Jensen wrote with Meckling, “The Nature of Man,” he cited the story of George Bernard Shaw asking an actress if she would sleep with him for a million dollars. When she agreed, he changed his offer to $10, to which she responded with outrage, asking him what kind of woman he thought she was. His reply: “We’ve already established that. Now we’re just haggling about the price.” The authors then concluded that we’re all whores. “Like it or not, individuals are willing to sacrifice a little of almost anything we care to name, even reputation or morality, for a sufficiently large quantity of other desired things.”

The solution they offered was premised on this cynical view of man and, having started from the assumption that we are all whores, they naturally ended up with prescriptions for making us well-behaved whores. “Unlike theories in the physical sciences,” wrote Sumantra Ghoshal, a professor at the London Business School, in his 2005 paper, “Bad Management Theories Are Destroying Good Management Practice,” “theories in the social sciences tend to be self-fulfilling…. This is precisely what has happened over the last several decades, converting our collective pessimism about managers into realized pathologies in management behaviors.”

In other words, if everybody assumes you’re a whore, you might as well grab as much money as possible while you’re still in demand. “[By] propagating ideologically inspired amoral theories, business schools have actively freed their students from any sense of moral responsibility,” concluded Ghoshal.

…Recent studies by the Aspen Institute show that when students enter business school, they believe that the purpose of a corporation is to produce goods and services for the benefit of society. When they graduate, they believe that it is to maximize shareholder value.

…Way back in 1951, the chairman of Standard Oil of New Jersey—the company founded by the ultimate robber baron, John D. Rockefeller—said: “The job of management is to maintain an equitable and working balance among the claims of the various directly affected interest groups…stockholder, employees, customers, and the public at large.” …In 2004, again with Murphy, Jensen wrote,… “Two hundred years of work in economics and finance implies that in the absence of externalities and monopoly,” he thundered, “social welfare is maximized when each firm in an economy maximizes its total market value.” …Ghoshal at the London Business School laid out a comprehensive rejection of agency theory. He began by dismantling Friedman’s—and by extension, Jensen’s—argument that shareholders are the “owners” of a company. They’re not, at least if by “own” one means it in the way one can own a car or an iPhone. “We…know that the value a company creates is produced through a combination of resources contributed by different constituencies,” Ghoshal wrote. “If the value creation is achieved by combining the resources of both employees and shareholders, why should the value distribution favor only the latter?”

The rat-actor paradigm says that corporations are rat-actors. This is much more realistic than assuming humans are selfish sociopaths because corporations really do have more incentives to behave like sociopaths. But even corporations also have an altruistic side because they are run by people who have altruistic impulses. Milton Freidman thought that that was terrible. He believed that corporations should behave purely selfishly and maximize profits like the rat-actor paradigm predicts.

Every company’s profits have to be arbitrarily divided between workers (wages), owners (profits), and people outside the company (through lower prices or less pollution or some other social benefit). Friedman and other proponents of the Principle-agent paradigm thought that employees should be purely altruistic towards owners to maximize their profits and that we should eliminate all altruism towards anyone else. He recognized that the rest of society can legitimately pass laws to prevent the company from hurting other people or damaging other’s property (such as by polluting), and he said that companies should abide by such laws, but corporations have considerable lobbying clout to shape our laws and Friedman’s argument says it is the moral duty of firms to lobby and bend the political system to allow more selfish profits such as by reducing pollution regulations and enhancing corporate political power.

This idea became so fashionable that it took on the weight of law. Shareholders can sue corporate executives if they do something that is good for society if it is at the expense of profits!  In practice, it is very rare, but a legal threat that is rarely enforced can have a big impact on behavior a bit like the threat of being fined for jaywalking is almost never carried out and yet most pedestrians try to avoid illegal crossings and mostly cross streets in the crosswalks.

Although Friedman’s supporters persist in defending the idea, it seems that at the 50th anniversary of Friedman’s famous essay, the idea is increasingly seen as a mistake. One of the challenges for the rat-actor view is explaining why many of the people who found corporations reject the idea.  For example, GE CEO Jack Welch called maximizing shareholder value “the dumbest idea in the world” and Yvon Chouinard, and John Mackey, founders of Patagonia and Whole Foods respectively reject it out of hand.  McDonald points out that the founders of Harvard, which is also a corporation, certainly would not have agreed either. McDonald cites Joel Bakan’s 2005 book, The Corporation: The Pathological Pursuit of Profit and Power, which interviewed Friedman:

the economist repeated the point he’d made nearly 40 years before [about maximizing profits], but with a twist. In Friedman’s view, “hypocrisy is virtuous when it serves the bottom line… [whereas] moral virtue is immoral when it does not.”

Friedman’s idea here is that Corporations should be hypocrites that do marketing to fool customers and suppliers into believing that they are altruistic because people are attracted to altruistic companies and that can boost profits.  But to actually be altruistic which means to sacrifice for the benefit of others, would be immoral according to Friedman.

Steve Denning traced the origin of this profit-maximization ideology to Milton Friedman and entitled another essay about it “pernicious nonsense“.

Bower/Paine… provides powerful rational arguments as to why shareholder value thinking is financially, economically, legally, socially and morally wrong. Yet there are powerful vested interests in keeping things as they are. As Upton Sinclair pointed out a century ago, “It’s hard to get a man to understand something when he is being paid not to understand it.”

In his book, Fixing the Game, Roger Martin makes the case that if the NFL had become corrupted by gambling and manipulation of the score, everyone would be calling on the NFL Commissioner to intervene and ban the coaches and players involved so that teams could get back to playing the real game of football. Yet in business, when it is now obvious that shareholder value thinking has corrupted management and has led to the massive extraction of assets and illegal stock price manipulation on a macro-economic scale, society has remained silent too long.

As Bower and Paine pointed out their 2011 book, Capitalism at Risk, the stakes are high. Amid widespread distrust of business, “you cannot achieve a sense of legitimacy if large numbers of people think that the system doesn’t work for them or is unjust to them.”  As the business ecosystem heads off the rails, business needs to act out of enlightened self-interest.

Business leaders must move beyond being simply practitioners of capitalism and become its stewards, working to enhance the sustainability of the market system.

Roger Martin wrote that corporations that prioritize a bigger mission often end up more profitable than corporations that prioritize profits over all else just like individuals who prioritize their mission and purpose in life usually end up happier than people who only focus directly on selfishly doing whatever makes them happy.

Aristotle once opined: if you seek happiness, you probably won’t end up happy; but if you seek to lead a worthy life, you are likely to end up happy. Shareholder value and happiness are counterproductive to pursue directly; rather they will happen when other things are pursued. Customer satisfaction is not the only defensible objective function. My friend Vineet Nayar argues that putting employees first is the best strategy – and he may be right. The key is to have a level playing field among objective functions. Let’s give the pursuit of each objective function – shareholder value, customers, employees – a chance to compete for success rather than swallowing the fallacious argument that having a singular objective function means that it has to be shareholder value maximization.

The problem with Friedman’s view are numerous.

  1. It is bad for profits because ethics and altruism are crucial for humans to work together productively.  That is why altruistic ethical norms evolved in every society.
    1. The rat-actor paradigm is bad for motivating employees.  Because people are altruistic and seek meaning in life, they want to do more in the 80,000 hours they spend in their careers than making money for rich shareholders.  Purely selfish employees will find ways to lie, cheat, and steal for their own benefit and that is bad for shareholder profits.
    2. The rat-actor paradigm is bad for motivating customers.  The customer relationship depends on trust and customers have more trust for businesses that have a moral compass.
    3. The rat-actor paradigm is bad for business-2-business relationships for the same reasons as above.
  2. It is bad for society.  Social responsibility is a social responsibility.  Corporations are some of society’s most powerful institutions and If none of our most powerful institutions were trying to make society a better place, we would be much poorer as a whole.  Friedman assumes that what is good for the stock market is good for everyone, but most people realize that the stock market is not a good measure of wellbeing.  The profit-maximization era has been an era when corporate profits rose at the expense of the rest of society.  It has been an age of stagnant median income and declining trust in each other.  These trends cannot continue long-term without hurting corporate profits and overall economic growth has slowed during this same era.  When society does not function well, corporations do not function well either, but there is a free-rider problem that prevents selfish actors from making any sacrifice to improve society.
  3. Friedman qualifies his recommendations by saying that corporations should follow the rules of society, but profit-maximizing corporations can often make much more profit by warping the rules of society through lobbying and PR campaigns than by improving their production.  By Friedman’s view, it is the moral duty of corporations to bribe government through whatever means is not technically illegal if it helps corporations pollute more and extract more wealth from society.
    • Furthermore, the rules of society do not and cannot determine what is truly moral.  For example, it is not illegal to commit adultery, but that does not mean that adultery is moral.  Similarly, it is illegal to not pay taxes on a dollar of cash earnings or to drive one MPH above the speed limit, but most people do not think that these are less moral than exercising our legal right to call people the N-word as is enshrined in our constituion.  The rules of society differ from place to place and from time to time, but that does not mean that what is truly ethical changes (unless you are a hard-core moral relativist).  Just because slavery was accepted by most societies for most of history doesn’t mean that slavery is usually OK.  We should all aim to do better than the minimum set by the rules of society.

For more, see Steven Pearlstein who wrote that “the cult of shareholder value wrecked American business” and few ideas in the history of management have had such a pernicious effect. Jia Lynn Yang wrote a history in the Washington Post focusing on how it revolutionized IBM. Two Harvard Business School professors, Joseph L. Bower and Lynn S. Paine, called it, “the error at the heart of corporate leadership” in the HBR.

Posted in Medianism
One comment on “Milton Friedman was not a rational actor
  1. […] the median American soured on big business for two main reasons.  First, US businesses adopted the Friedman doctrine in which Milton Friedman argued that the ONLY responsibility of business was to maximize profits […]

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