Advantages of Wealth Maximization Model. Wealth maximization model is a superior model because it obviates all the drawbacks of profit maximization as a goal of a financial decision. Firstly, the wealth maximization is based on cash flows and not on profits. Unlike the profits, cash flows are exact and definite and therefore avoid any ambiguity. A profit-maximizing firm will produce m ore output when marginal revenue is m ore than the marginal cost and less output when marginal r evenue is less than the marginal cos t. Profit Maximization Goal Objective: Large amount of profits Advantages: 1. Easy to calculate profits 2. Easy to determine the link between financial decisions and profits Disadvantages: 1. Advantages And Disadvantages Of Profit Maximization Pdf Norton Classic air-cooled twin-rotor motorcycle The Wankel engine is a type of using an to convert pressure into rotating motion. Contents. Concept and design The design was.
Where Friedman was wrong
In 1970, the late Milton Friedman of the University of Chicago famously argued that corporate managers should “conduct the business in accordance with [shareholders’] 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.”
Since then, Friedman’s view that the sole social responsibility of the firm is to maximize profits—leaving ethical questions to individuals and governments—has become dominant in both finance and law. It also laid the intellectual foundations for the “shareholder value” revolution of the 1980s.
Friedman’s position has been attacked by many critics on the grounds that corporate boards should consider other stakeholders in their decisions. Yet, if the owner of a privately held firm is under no obligation to care about anybody’s interest but her own, why should it be different for a publicly traded company?
While agreeing with Friedman’s premise that managers should care only about shareholders’ interests, Nobel Laureate Oliver Hart of Harvard and Chicago Booth’s Luigi Zingales reject the view that shareholders care only about money. A company’s ultimate shareholders are ordinary people who, in addition to caring about money, are also concerned about a myriad of ethical and social issues: they purchase electric cars to lower their carbon footprint; they buy free-range chicken or fair-trade coffee because they view this as the ethical—albeit more expensive—choice. They are, in other words, prosocial in their day-to-day life—at least to some extent. “If consumers and owners of private companies take social factors into account and internalize externalities in their own behavior, why would they not want the public companies they invest in to do the same?” Hart and Zingales ask.
Friedman recognized that in some cases shareholders may have different objectives, but he concluded these objectives are better pursued by the shareholders on their own. This is certainly the case for Friedman’s leading example: corporate charity. Ignoring tax considerations, according to Friedman, it is preferable that the money spent in corporate philanthropy be paid out to shareholders in the form of dividends and then allocated by them to charity, rather than allocated by corporate managers directly.
Hart and Zingales argue that this conclusion holds only under the assumption that shareholders can individually reproduce or undo any corporate decision, without incurring any additional cost. This assumption holds for charity: a dollar in charity is the same whether it is donated by an individual or by a corporation. But it does not hold for most other social objectives: an individual cannot generally undo corporate pollution at the same cost that a company would have paid to avoid it. In this more general case, Hart and Zingales conclude that a company’s objective should be the maximization of shareholders’ welfare, not value.
Asher Schechter is a writer and editor of ProMarket, the blog of Chicago Booth’s George J. Stigler Center for the Study of the Economy and the State. This is an excerpt of a post that first appeared on the blog, at ProMarket.org.
A small step for theory, a leap forward in governance
Since we published our recent paper, we have received criticism of the interpretation published on the ProMarket blog. One writer claims that the title of the post (“Where Friedman was wrong”) is misleading. His argument is based on the fact that Friedman was well aware that “human beings maximize utility, not income” and that people considering this discussion “are still saying that shareholder interests come first and only for a company; [they’re] just agreeing, as Friedman would, that those interests are shareholder utility, not money exclusively.”
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We feel obliged to intervene and clarify. We agree that Friedman believed that people maximize utility, not income. In fact, in his 1970 article in the New York Times Magazine, he writes that the desire of shareholders “generally will be to make as much money as possible.” The “generally” indicates that he recognizes that shareholders sometimes have other objectives. Yet, Friedman concludes that “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits.”
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Friedman can conclude this because he has in mind a world where social activity and profit-making activity are completely independent (as is the case for corporate charity). There is no loss of efficiency in letting shareholders decide which charities should be financed. Under this restrictive assumption, Friedman’s conclusion is right. In the more general case—where, for example, undoing pollution is more expensive than curbing it to begin with—Friedman’s conclusion does not follow logically. In this respect, Friedman was wrong. Hence, the legitimacy of the title.
We admire Friedman and we have no desire to prove him wrong. What we do want is to correct a diffuse and consequential mistake that is generally made in teaching finance. We looked at the five most cited corporate finance textbooks. Four explicitly mention shareholder value maximization as an objective. None mentions shareholder welfare maximization.
More importantly, we want to correct the mistake that our teaching has produced as to the way public corporations are run. The figure (see “Profit-minded philosophy,” this page) shows the percentage of Dow Jones Industrial Average companies that mention value maximization as an objective: Friedman’s rule and MBA teaching had some impact on business practices. It was on the basis of this principle that the board of Wal-Mart opposed the inclusion in the proxy ballot of a shareholders’ proposal aimed at reconsidering the sale of high-capacity magazines, the ones used in mass shootings. It is on the basis of the shareholder-value principle that corporate boards and courts of law reject the ability of shareholders to influence corporate policy on important issues that shareholders care about. Moving from shareholder value maximization to shareholder welfare maximization may be a small step in theory, but it could trigger a leap forward in the way our corporations are run.
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Oliver Hart is Andrew E. Furer Professor of Economics at Harvard University. Luigi Zingales is Robert C. McCormack Distinguished Service Professor of Entrepreneurship and Finance and Charles M. Harper Faculty Fellow at Chicago Booth. Their response also appeared on ProMarket.