David R. Henderson  

Maximizing Short-Run Profits

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I was one of three speakers on a panel at the San Francisco Federal Reserve Bank on Wednesday. The other two speakers were Kevin Lansing of the SF Fed and Atif Mian of Princeton University. The event went well and I'll have a few posts on it in the next few days.

But I want to focus on something that one of the audience members raised with me in a conversation after the formal event ended. He said matter-of-factly, as if there were no doubt, that profit-maximing companies maximize short-run profits at the expense of the long run. "If that were true," I replied, "then drug companies should end all R&D today. Their R&D expenses would fall and their profits would rise. And yet we don't see them doing that. They invest hundreds of millions of dollars in drugs that, in many cases, will not bring good earnings to them for a few years and maybe for 10 or more years."

The man replied that he knew that because he had been a top manager at Amgen. Later I looked him up on the web and, sure enough, he had been. "So that's my point," I said. "You know from personal experience that drug companies are not maximizing short-term profits."

Here's the interesting thing: I don't think I made a dent in his thinking. I'm not sure, but there was no acknowledgement on his part of the connection between my drug-company evidence, which he admitted, and his claim.

This could be an instance of someone who just has trouble admitting in real time that he's wrong. I see that all time, and I put a substantial probability on it. But my gut feel is that it's something else: I think he heard this line about for-profit companies maximizing short-term earnings at the expense of the long run and is just repeating it as a good line but one that he hasn't really thought about.

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CATEGORIES: Business Economics

COMMENTS (14 to date)
Pajser writes:

I think he tried to say "it would be better for humanity if companies optimize profit for longer terms than they on average do" and after your answer he concluded that it leads into too complicated discussion for that situation.

Tracy W writes:

I've been reading about cognitive science, and it seems quite clear that our brains mostly work by forming linkages between ideas through experiencing the two ideas being associated. The more times we experience that association, the more available the association is in the future. So, if we don't know that two ideas are logically associated we're quite unlikely to associate them, if we've been told once, we're a bit more likely to associate them, if we repeatedly keep finding them together then eventually this link becomes rock-solid. Dan Willingham talks about this as knowledge going from being inflexible to flexible, and that the inflexible stage seems to be an unavoidable part of learning.

This explained to me the tramping (NZ hiking) advice, that, when making decisions about whether to go into wild weather or stay put, to think of some very experienced tramper you know and ask "What would Lee {or whatever their name is) do?" That gets your brain to activate the the thought of Lee, which then leads it to all the associations of Lee's experience that you've seen or heard of. Which can be much more effective than just thinking "what should I do".
I use this at work, I think "What would Deborah say?" when designing something and that forces me to be much more conscientious.

So, in this case, presumably your questioner just never put the two ideas together. And that it will take a fair few more repetitions for him to get in the habit of doing so.

(This does leave as a mystery how come anyone ever does in the first place. From the cognitive scientists' descriptions of their experiments, I gather this does happen, but they talk much more about the average results than the exceptions.)

Al writes:

He may have been trying to communicate the incentives to maximize soon to be realized profits, to the extent that they can justify it to investors. Management has to consider the possibility that they may be pushed out before their options vest, so projects that fully impact performance metrics in the distant future might require additional discounting.

Also, if the shareholders turnover every 3-5 years, then they are looking changes in market expectations over that time frame. Management can engage in some real investment and then try to communicate their plans to the shareholder base, thus accepting the risk that such expectations could change in a career jeopardizing manner. Or management can do short-term strategies to boost cash flow, while STILL communicating long term vision to the shareholder base. If the long term vision doesn't work out, well, management probably reduced their company exposure in the meantime.

It really depends on what shareholders say they want versus how management is actually rewarded.

john hare writes:

As part of a talk I did last week to a conservative group, I said that we do not pay our politicians enough to get the top talent. I gave rookie football and baseball players salaries compared to congress and the president respectively. I also mentioned the top CEOs making tens to hundreds of millions per year. I said that any group that perceives itself as underpaid will be far more susceptible to collecting otherwise, and that if we don't pay the bill, someone else will. People answer to whoever is signing the paycheck and we as citizens are not. I had your Singapore example in mind though I didn't mention that.

The feedback was that Benjamin Franklin said that serving in government should be a service and not a career or similar statements. If that part of my talk had any effect, it was in stealth mode.

Brandon Berg writes:

I see this a lot. It's one of those left-wing shibboleths that get repeated ad nauseam despite the fact that it doesn't hold up to the slightest bit of scrutiny. Another good counterexample is the timber industry. Trees can take decades to mature, yet these supposedly myopic corporations keep planting them.

Many of the people who parrot this sentiment likely also believe that small businesses are preferable to large corporations, yet large corporations are in a much better position to engage in long-term planning than are small businesses, which often struggle to make payroll.

Tom West writes:

I've found that statements that are at odds with the facts often reflect a person's inability to articulate a somewhat more complicated belief.

In the example above, I can imagine that R&D spending has many different components, and it's quite possible that in the speakers opinion, such spending has shifted from basic research, which may take decades to pay for itself, to development, which is supposed to pay for itself within a year or two, to the detriment of the long-term future of the company.

This move towards "shorter-termism" becomes a nebulous "they only think about the short-term" and that's what get's spoken.

If sufficiently interested, I will often use conversation to try and tease out the actual belief behind a statement that is patently false on the face of it. Usually it's quite a bit less absurd.

Art Carden writes:

This is a common-enough sneer that it's become part of the unquestioned and unreflective received wisdom about capitalism and, in a non sequitur, a claim that state action is necessary.

This reflects a clear failing in economics education. While (say) the personal finance chapter of Cowen and Tabarrok is decent, we don't spend enough time in principles classes unraveling the mystery of prices for goods, prices for services, and prices for financial assets. Note to self: fix that this Fall.

MG writes:

Well, if the interlocutors are stuck on their "corporations maximize short-term profits at the expense of long-term profits" against all evidence, why not challenge them by agreeing it is "true" and then asking: "Is this hapening because government policy (action and inaction) had left us facing an incredibly steep risk-discount curve?" Or "Yeah, impatience is all around us. By the way, whose incentives-controls appear better able to help counter-balance impatience, those of private sector owners' or those of elected political operatives'?

Maniel writes:

@Pasjer & @AI
Good job of confirming Prof. Henderson’s observation that “there was no acknowledgement … of the connection between my … evidence … and his claim.” Your interpretations of what Former Amgen “tried to say” or “may have been trying to communicate” are supportive of Former Amgen’s apparent inclination to dismiss data which cast doubt on a religious misconception.

"Is this hapening because government policy (action and inaction) had left us facing an incredibly steep risk-discount curve?"

Almost lost in the mists of time: There was a piece by Alan Greenspan in Hoover's The United States in the 1980s, in which he quantifies the phenomenon. Showed that the average length of long term inivestment projects had decline in the 1970s, by a very significant amount.

Joe Teicher writes:

I think this person had a valid point that he just didn't express correctly. The manger of many publicly traded companies, especially those without any strong activist owners, focus on satisfying the short term expectations of analysts at perhaps the expense of long term performance. Wall street expectations are not the same thing as profits, since analysts focus on multiple metrics, but the point is that many managements will fail to do things that have positive long term consequences if they temporarily make those metrics look worse.

Warren Buffett has long stated that a competitive advantage of Berkshire is that his concentrated ownership allows him to ignore wall street expectations and make economically rational decisions even if they make short term metrics look bad. It would be interesting to see you debate that point with him.

Enial Cattesi writes:

This is a variation on the old prejudice that private enterprises are driven by profit, hence bad, while public bureaucrats aren't driven by profit, hence good. It is just lack of economic understanding of what profits are.

Brandon Berg writes:

Joe Teicher:
How would we know? Of all the people outside the company, analysts are probably in the best position to see what's really going on. If they're fooled, how do we find out?

Tom West writes:

Brandon Berg:
Why would analysts hold horizons that are any different from the majority of the stock holders?

Personally, what I usually see sacrificed for short term gain is not so much future growth as robustness. Robustness is expensive, hard to measure, and rarely valued by the market or the customer (more accurately, they assume equal robustness among all competitors).

While I view this trend with no little horror, if experience has taught me anything, it's that it's almost certainly economically rational to do so, at least once you've built a reputation. Reputations take a *long* while to destroy, and for big customers, quality and reliability of product are usually far less important than price, reputation, and the quality of the sales force.

All reasons why I would be an utter failure in the executive suite :-).

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