The Economic Supremacy of Survival over Profit Maximization

Aaron Blackburn Fall 2010

1 It is commonly thought that the foremost goal of any business is maximizing profits. Faced with the complexity of the world, this seems too simple and straight-forward. Peter F. Drucker and Armen A. Alchian both reject it. They argue from differing, yet agreeable, pointsof-view on what really drives a company, and how profit maximization does not have a place with what they find most important: survival. It is a reality that Henry Mintzberg supports in his own myth-dispelling characterization of organizations leading force: managers. These three authors, in their own ways, show that businesses are shaped by more complex forces than getting the most. Peter F. Drucker begins the fifth chapter of Management: Tasks, Responsibilities, Practices by examining the role of management in the creation of business. Economic forces set limits to what management can do. They create opportunities for managements action. But they do not by themselves determine what a business is or what it does. Nothing could be sillier than the oft-repeated assertion that management only adapts the business to the forces of the market. Management not only has to find these forces, it has to create them (Drucker, p. 58). The assertion is that the economy does not define what particular businesses exist, anymore than do businesses simply change with the economy to suit their needs. Rather, organizations must find and/or create opportunities within the economy in which to thrive. The need for a company to survive is its true goal, according to Drucker, not profit maximization. The first test of any business is not the maximization of profit but the achievement of sufficient profit to cover the risks of economic activity and thus avoid loss (Drucker, p. 60). While this seems quite elementary, it is often believed that a business seeks only to maximize its profits. However, this theoretical objective overshadows the basic reality that an organization needs income first and foremost to continue. Drucker then decides to focus

2 on the purpose of a business. A more detailed discussion of profit maximization will follow later. Since Drucker dismissed the maximization of profit as the driver behind companies, he then delves into what their goal is. There is only one valid definition of business purpose: to create a customer (Drucker, p. 61). This circumvents the more common view that companies seek to sell a product or service. Indeed, if there were no customers, then the products and services would have no purpose in of themselves. Drucker elaborates this point: What the customer thinks he is buying, what he considers value, is decisive it determines what a business is, what is produces, and whether it will prosper. And what the customer buys and considers value is never a product. It is always utility, that is, what a product or service does for him (Drucker, p. 61). It is not the product or service that holds the value, but what it gives the customer. Therefore, if a company provides value, it creates its own customers, and finally profit to survive. To meet this need, organizations must focus on the activities that will fulfill it. Because its purpose is to create a customer, the business enterprise has two and only these two basic functions: marketing and innovation (Drucker, p. 61). It is then marketing and innovation that make a product or service valuable to the customer. And Drucker expands on how marketing and innovation increases the value. The aim of marketing is to know and understand the customer so well that the product or service fits him and sells itself (Drucker, p. 64). Marketing then is a form of education for both parties, the organization learning the needs of the customer, and the customer learning the value of the product or service. With innovation Drucker is more specific: The most productive innovation is a different product or service creating a new potential of satisfaction, rather than an improvement (Drucker, p. 65). The best chance a

3 company has of creating a customer is then to make something that meets a previously unknown or unattainable need. It is by marketing and innovation that a business creates its customers, and therefore survives. However, creating a customer is not only an end of itself for Drucker. The enterprise must utilize wealth-producing resources to discharge its purpose of creating a customer. It is, therefore, charged with productive utilization of these resources. This is the administrative function of business. In its economic aspect it is called productivity (Drucker, p. 67). If the resources employed by an organization are not productive, then marketing and innovation cannot create a customer. This has a greater consequence besides the end of a business. The business that fails to produce an adequate profit imperils both the integrity of the resources entrusted in its care and the economys capacity to grow (Drucker p. 73). The productive use of these resources then not only helps the company survive, but also profits the customer in the form of a valuable product or service, and profits the economy by increasing the exchanges between customers and businesses. This leads back to Druckers central question: What, then, is managing a business? It follows from the analysis of business activity as the creation of a customer through marketing and innovation that managing a business must always be entrepreneurial in character (Drucker, p. 73). It is not profit maximization that is a business primarily concern. It is the basic survival of the organization, based on creating value, which drives its actions. The idea of survival is central in Armen A. Alchians Uncertainty, Evolution, and Economic Theory. The suggested approach embodies the principles of biological evolution and natural selection by interpreting the economic system as an adoptive mechanism which chooses among exploratory actions generated by the adaptive pursuit of success or

4 profits(Alchian, p. 211). For Drucker, survival depends on an organizations ability to create value and by extension customers. Alchian puts more emphasis on the economy by suggesting it changes to make those successful businesses the standard. As with Drucker, Alchian does not see profit maximization as primary force behind a business. First, to clear the ground, a brief statement is given of a generally ignored aspect of profit maximization, that is, where foresight is uncertain, profit maximization is meaningless as a guide to specifiable action (Alchian, p. 211). As a company and the individuals within it are not able to predict the future, they cannot choose which actions will lead to the greatest profits possible. Therefore, organizations do not act according to what will lead to this maximization, but what is necessary for survival. It is the results, not the motivation, which Alchian sees as the measure of a companys success. Realized positive profits, not maximum profits, are the mark of success and viability. It does not matter through what process of reasoning or motivation such success was achieved. The fact of its accomplishment is sufficient. This is the criterion by which the economic system selects survivors: those who realize positive profits are the survivors; those who suffer losses disappear (Alchian, p. 212). While Drucker proposes that the process does matter, and centers on value and customer creation, Alchian takes a post-procedural stance in that the result proves whether or not an organization will last. It is these results that define how the economic system will adapt to the winners. Alchian sees luck and adaption as ways to obtain success. Sheer chance is a substantial element in determining the situation selected and also in determining its appropriateness or viability. A second element is the ability to adapt ones self by various methods to an appropriate situation (Alchian, p. 214). This compliments the uncertainty of the economic

5 future that Alchian discussed with the falsehood of profit maximization. Because a company is not able to foresee what will happen, takes a combination of good fortune and the ability to change to find what will work. However, Alchian does not give total credit to successful organizations. More common types, the survivors, may appear to be those having adapted themselves to the environment, whereas the truth may well be that the environment has adopted them. There may have been no motivated individual adapting but, instead, only environmental adopting (Alchian, p. 214). To Alchian, it is important to keep in mind that the survival of a business may not have been the result of their actions, but the economic system finding them to be the most successful. However, Alchian does not imply that all planning on the part of business be abandoned for chance. The essential point is that individual motivation and foresight, while sufficient, are not necessary. Of course, it is not argued here that therefore it is absent. All that is needed by economists is their own awareness of the survival conditions and criteria of the economic system and a group of participants who submit various combinations and organizations for the systems selection and adoption (Alchian, p. 217). Knowing how the economic system and its components are changing to meet the situation will reveal what is most successful. Contrary to Druckers insistence on creating value, Alchian sees value in terms of being able to determine conditions. Adaption through imitation or trail-and-error can have mixed results according to Alchian. When it comes to imitation, Unfortunately, failure or success often reflects the willingness to abandon it at the right time and circumstances. Those who are different and successful become innovators, while those who fail become reckless violators of tried-andtrue rules (Alchian, p. 218). Not much faith is put into imitation, mostly because of the

6 uncertainty of when to innovate. This uncertainty also plays into trail-and-error methodology. Comparability of resulting situations is destroyed by the changing environment. As a consequence, the measure of goodness of actions in anything except a tolerable-intolerable sense is lost, and the possibility of an individuals converging to the optimum activity via a trial-anderror process disappears. Trial and error becomes survival or death. It cannot serve as a basis of the individuals method of convergence to a maximum or optimum position (Alchian, p. 219). Since the economic system is constantly adapting to new successes, trail-and-error processes have just as much random chance of success as knowing when to imitate and when to mutate. The endpoint for Alchian is not a firm process that leads to profit. What really counts is the various actions actually tried, for it is from these that success is selected, not from some set of perfect actions (Alchian, p. 220). This seems to contradict Alchians previous warnings of imitation and trail-and-error adaption. However it is this very tension between chance and planning that should force an organization to adapt as the economic system adapts to the successful. It is adaptation and survival, not profit maximization, which makes for a successful company; and Drucker agrees. As previously mentioned, Drucker does not accept profit maximization as impetus of commercial organizations. This opinion is not just because it distracts from the true nature of business. As he writes about profit maximization: In fact, the concept is worse than irrelevant: it does harm. It is a major cause for the misunderstanding of the nature of profit in our society and for the deep-seated hostility to profit which are among the most dangerous diseases of an industrial society. It is largely responsible for the worst mistakes of public policy in this country as well as in Western Europe which are squarely based on the failure to

7 understand the nature, function, and purpose of business enterprise. And it is in large part responsible for the prevailing belief that there is an inherent contradiction between profit and a companys ability to make a social contribution. Actually, a company can make a social contribution only if it is highly profitable. (Drucker, p. 60) Since profit maximization skews public perception of earnings, it is also detrimental to The public understanding of what the purpose of business is. Business is therefore needlessly constricted in the name of social good, robbing it of the ability to contribute to the community in which it inhabits. And if the business is limited to the point of unprofitability, the people who constitute the organization may loose their livelihood and their ability to contribute to the world. However, Drucker does not just dismiss profit. He is cautious towards it: Not every management can do everything, nor should any business necessarily go into those activities which seem objectively to be most profitable. Every management has specific abilities and limitations. Whenever it attempts to go beyond these, it is likely to fail, no matter how inherently profitable the venture (Drucker, p. 70). This observation compliments his anti-profit maximization view. It shows how it not only misleads public opinion, but also the managers of a company as well. And as profit maximization is a misconception of the nature of business, there is a misconception of profit. Profit is something else: Profit is not a cause but a result the result of the performance of the business in marketing, innovation, and productivity. It is a needed result, serving essential economic functions (Drucker, p. 71). Profit is not an end, but a way of assessing how an organization is performing. Even though all organizations undergo a period of unprofitability, the lack of profit can give the company signals that it needs to change, and signals that there is a

8 space in the economy for a better performer. Of course, innovation and invention carry risk, and Drucker sees how profit helps with risk. Profit has a second function which is equally important. It is the premium for the risk of uncertainty (Drucker, p. 72). Profit is the payoff for trying to create value for a customer. It is more than the fuel for marketing, innovation, and productivity necessary to create this value. It induces these activities, feeding the economy. The existence of profit is important for Drucker, not seeking it in its greatest quantity. Drucker does not care for the concept of profit maximization, which he finds misleading. Alchian does not just find it misleading, but denies its possibility. He references the economist G. Tintner. He denies that profit maximization even makes any sense where there is uncertaintyUnder uncertainty, by definition, each action that may be chosen is identified with a distribution of potential outcomes, not with a unique outcomeEssentially, the task is converted into making a decision (selecting an action) whose potential outcome distribution is preferable, that is, choosing the action with optimum distribution, since there is no such thing as a maximizing distribution (Alchian, p. 212). In essence, without the ability to foresee the outcome of every business activity, there is no way to choose the one that will maximize profits. He elaborates: In the presence of uncertainty a necessary condition for the existence of profits there is no meaningful criterion for selecting the decision that will maximize profits (Alchian, p. 212). Where Drucker is concerned with the harm the idea generates in society, Alchian makes a point that it should be ignored as impossible. Alchian freely admits that uncertainty, which negates profit maximization for him, is the space in which actual profits is attainable. Although Drucker called profit a premium for engaging uncertainty, it is hard to see where he and Alchian disagree on the connection between profit and uncertainty.

9 This paper has made several comparisons between the views of Drucker and Alchian. Besides seeing a relationship between profit and uncertainty, they also advocating moving away from the idea of profit maximization. But there is disagreement in how a company survives. Drucker believes the organization needs to use marketing, innovation, and productivity to create value to create the customer that will lead to profits and thus survival. Alchian sees the economy adapting to the successful; whom with their own luck and ability to adapt have survived. The differences are subtle, yet Drucker portrays businesses as being the sole proponent of their survival. Alchians view is more biological, where the environment and its inhabitants are inseparable and each changes the other. These economic philosophies are incompatible in how the survivors come to be, but compatible in that survival does not depend on profit maximization. There is yet another impracticality to this ideal, the facts of the job for those who run businesses. The facts Henry Mintzberg gives in his The Managers Job: Folklore and Fact explain how on a managerial level survival, not profit maximization, is the primary goal. These facts are expressed in the variety of role managers must fill. This leaves them without the willingness and time to ponder how to maximize profits. Drucker understands the importance of the managers time. The most productive or least productive time is that of the manager himself. Yet it is usually the least known, least analyzed, least managed of all factors of productivity (Drucker, p. 70). The variety of work allows the organization chances to change for their survival, and not much else. Managers work at an unrelenting pace, that their activities are characterized by brevity, variety, and discontinuity, and that they are strongly oriented to action and dislike reflective activities (Mintzberg, p. 164). This includes being an entrepreneur, [seeking] to improve the

10 unit, to adapt it to changing conditions in the environment, the disturbance handler involuntarily responding to pressures, responsible for deciding who will get what as the resource allocator, and negotiator (Mintzberg, p. 171,2). Alchian would see the entrepreneur, the liaison role, in which the manager makes contacts outside the vertical chain of command and the monitorperpetually scanning the environment for information (Mintzberg, p. 166,9) as the manager that looks for the next adaptation to take. Drucker would see them as ways managers try to create new value. And yet other roles demand more attention from those in charge. For managers, their work involves performing a number of regular duties, including the figurehead the head of an organizational unit and responsible for the work of the people of their unit as the leader (Mintzberg, p. 165,8). These roles have their own time requirements that focus managers on the people and projects for which they are responsible. With time as a premium, managers strongly favor verbal media, which makes them a disseminator, [passing] privileged information directly to subordinates, who would otherwise have no access to it, and a spokesperson, [sending] some information to people outside the unit (Mintzberg, p. 166,71). This reveals another fact about managers, their programs to schedule time, process information, make decisions, and so on remain locked deep inside their brains (Mintzberg, p. 167). Information sharing then is another key part of the managers survival, and by extension, his or hers company. This relational aspect of the managers job is necessary. These roles would not be needed if managers could make the correct choices to maximize profit. What does the high level of personal contact a manager must give show? That at the heart of the business enterprise is relationships and the people involved, not profit maximization, which the survival of the organization depends. For Peter F. Drucker, this is seen in people

11 learning to use marketing, innovation, and productivity. And for Armen A. Alchian it is people learning to change with an every adapting economic system. With either point-of-view, the relationships are necessary to arrive at a profit, not in a philosophical maximum, and a continuation of the business itself. WORKS CITED

Alchian, Armen A. Uncertainty, Evolution, and Economic Theory. The Journal of Political Economy. Vol. 58 No. 3 (June, 1950). Pages 211-221.

Drucker, Peter F. Management: Tasks, Responsibilities, Practices. New York: Harper & Row. 1974

Mintzberg, Henry. The Managers Job: Folklore and Fact. Harvard Business Review. MarchApril 1990. Pages 163-176.