Value Creation Principles

The Pragmatic Theory of the Firm Begins with Purpose and Ends with Sustainable Capitalism

Bartley J. Madden

• Publisher: Wiley
• Year: 2020
• ISBN:
  9781119706649
• Edition: 1
• Topic: Business
• Subtopic: Finanza
• Index: Business

PRAISE FOR VALUE CREATION PRINCIPLES

"In Value Creation Principles, Madden introduces the Pragmatic Theory of the Firm that positions the firm as a system fueled by human capital, innovation, and, at a deeper level, imagination. He challenges us to understand how we know what we think we know in order to better discover faulty assumptions that often are camouflaged by language. His knowledge building loop offers guideposts to design experiments and organize feedback to facilitate early adaptation to a changed environment and to avoid being mired in ways of thinking rooted in 'knowledge' of what worked well in the past—a context far different from the context of today. His book explains a way of being that enables those who work for, or invest in, business firms to see beyond accounting silos and short-term quarterly earnings and to focus on capabilities instrumental for creating long-term future and sustainable value for the firm's stakeholders. I can't recommend this astounding book enough especially given its deep and timely insights for our world today."
—John Seely Brown, former Chief Scientist for Xerox Corp and Director of its Palo Alto Research Center (PARC); co-author with Ann Pendleton-Jullian of Design Unbound: Designing for Emergence in a White Water World

"In contrast to existing abstract theories of the firm, Madden's pragmatic theory of the firm connects management's decisions in a practical way to a firm's life cycle and market valuation. The book promotes a firm's knowledge building proficiency, relative to competitors, as the fundamental driver of a firm's long-term performance, which leads to insights about organizational capabilities, intangible assets, and excess shareholder returns. Value Creation Principles is ideally suited to facilitate progress in the New Economy by opening up the process by which firms build knowledge and create value, which is a needed step in revising how neoclassical economics treats the firm."
—Tyler Cowen, Professor of Economics, George Mason University; co-author of the popular economics blog Marginal Revolution

"Bartley Madden rightfully points out that both textbook and more advanced economic theories of the firm fail to address the concerns of top management and boards of directors. He offers a tantalizing pragmatic alternative that directly connects to quantitative changes in the firm's market value. His framework gives recognition to the importance of intangible assets, and his pragmatic approach is quite complementary to the Dynamic Capabilities framework that strategic managers implicitly and sometimes explicitly employ."
—David J. Teece, Thomas W. Tusher Professor in Global Business, Faculty Director, Tusher Center for the Management of Intellectual Capital, Haas School of Business, University of California, Berkeley

Part I
A Firm's Role in Society

1
OVERVIEW OF THE PRAGMATIC THEORY OF THE FIRM

In my experience, motivating employees with a sense of purpose is the only way to deliver innovative products, superior service, and unsurpassed quality over the long haul.… An organization of highly motivated people is hard to duplicate. The motivation will last if it is deeply rooted in employees' commitment to the intrinsic purpose of their work.

—Bill George¹

Business ethics, then, has to do with the authenticity and integrity of the enterprise.… Those who cannot serve the corporate vision are not authentic businesspeople and, therefore, are not ethical in the business sense.… In a company, a leader is a person who understands, interprets, and manages the corporate value system. Effective managers, therefore, are action-oriented people who resolve conflict, are tolerant of ambiguity, stress, and change, and have a strong sense of purpose for themselves and their organizations.

—Bowen H. McCoy²

Theories of the firm arise from the motivations of their developers. They initially define a firm in a way that is compatible with their objectives and their worldview. This chapter shows how theories of the firm evolved in the disciplines of economics, finance, and management. In addition, this review places the pragmatic theory of the firm in historical context, highlights the main differences separating the pragmatic theory from alternative theories, and provides an initial assessment of its usefulness.

THE NUCLEUS OF THE PRAGMATIC THEORY OF THE FIRM

Any theory of the firm involves an answer to this question: What is a firm? The pragmatic theory defines a firm as a dynamic system of coordinated activities that evolves as management and employees build knowledge in order to efficiently create value for customers, and that knowledge-building proficiency, relative to competitors, determines a firm's life cycle and the extent of rewards to its stakeholders over time.

How should the usefulness of the pragmatic theory of the firm be gauged versus other theories of the firm? Six metrics can help.

1. Clarity about the firm's purpose. Any theory about the functioning of a firm needs to be clear about how the purpose of the firm provides guidelines for creating value for all of the firm's stakeholders. As the above quote by Bill George, former CEO of Medtronic, emphasizes, a firm's purpose is its bedrock foundation.
2. Source of competitive advantage. The pragmatic theory specifies that the source of long-term competitive advantage (disadvantage) is a firm's knowledge-building proficiency being greater (less) than competitors. This stake in the ground can help management prioritize performance improvement projects. How often do we hear that capability X is the key to a firm's competitive advantage? But, shouldn't the question of interest be: What is the source for improving capability X over time? And the answer circles back to a firm's knowledge-building proficiency.
3. Understanding the firm's market valuation. A strong suit of the pragmatic theory is how it connects a firm's core activities (e.g., work, innovation, and resource allocation) to its publicly traded market value (estimated for privately held firms). Currently, important issues tend to be analyzed without treating the firm as a dynamic, holistic system. For example, academic finance has a theory of asset pricing—the Capital Asset Pricing Model (CAPM) and its variations, which tie together risk and return. This equilibrium theory of asset pricing has been applied in accounting, management, and economic research because heretofore theories of the firm were incomplete due to ignoring key variables concerned with the market valuation of firms. However, the pragmatic theory of the firm provides new angles of thinking about important finance/management issues such as risk, cost of capital, intangible assets, competitive advantage, firm performance, resource allocation, and valuation. For many, this will be a transition that agrees with their business intuition by avoiding the constraint of firm risk being synonymous with the extent of co-movement (Beta) of a firm's stock price with the general market regardless of a firm's ability to be a viable competitor in an increasingly tough global business environment. The pragmatic theory leads to testable hypotheses about firm performance and shareholder returns (see Chapter 5).
4. Source of improved operating performance. The pragmatic theory predicts that performance of managerial tasks (e.g., strategy formulation, new product development, quality control, etc.) will improve as managers gain mastery in traversing the knowledge-building loop that is described in Chapter 2.
5. Source of improved managerial decisions. Management is well served by constructive skepticism as to what they think they know. The pragmatic theory views knowledge building as the foundation for value creation.
6. Analysis of firms. Not only managements, boards, and investors, but also academic researchers and business students can benefit from studying firms' long-term track records guided by the pragmatic theory of the firm. This promotes the study of value creation through deep understanding of the histories of firms, including a comprehension of what drives a firm's stock price over the long term—an especially important readout of long-term value creation. Moreover, economists tend to measure how value is created in a society via macroeconomic variables and industry analyses. The pragmatic theory of the firm equips economists (and their students) with a useful framework for evaluating the locus of value creation at the individual firm level, a highly beneficial microanalysis supplement.

The pragmatic theory of the firm addresses both the actual operations of a firm and a variety of practical needs for those relying on a theory of the firm—hence the label pragmatic. The next section presents a historical synopsis of how thinking about the theory of the firm has evolved. Keep in mind that theories have been tailor-made for certain academic disciplines and specific purposes and are not easily applied across disciplines. In contrast, the pragmatic theory of the firm should be useful across economics, finance, management, and other disciplines because it provides insights regarding each of the above six metrics.³

THE EVOLUTION OF THINKING ABOUT THE THEORY OF THE FIRM

If a theory of the firm is to be widely useful, it necessarily must deal with how a firm is managed. One of the earliest statements clearly acknowledging this need is found in an 1886 speech, “The Engineer as an Economist,” presented to the American Society of Mechanical Engineers by Henry R. Towne, cofounder of the Yale Lock Manufacturing Company.

There are many good mechanical engineers—there are also many good businessmen—but the two are rarely combined in one person. But this combination of qualities, together with at least some skill as an accountant, either in one person or more, is essential to the successful management of industrial works, and has its highest effectiveness if united in one person, who is thus qualified to supervise, either personally or through assistants, the operations of all departments of a business, and to subordinate each to the harmonious development of the whole [i.e., systems thinking].⁴

In 1911, Fredrick Taylor published Principles of Scientific Management, which focused in the extreme on quantitative measurement to develop “the one best way” to accomplish specific tasks. In short, management should develop the required knowledge and then command employees to follow the prescribed routines. Taylor's worldview did not embrace win-win partnerships that continually developed employees' problem-solving skills while simultaneously increasing job satisfaction.

Meanwhile, the economist Alfred Marshall's book, Principles of Economics, first published in 1890 and revised in eight subsequent editions, became the dominant economic textbook for decades. Marshall cemented the use of supply-and-demand curves, marginal cost, elasticity, and many other important concepts tied together as a system of partial equilibrium. His book became the foundation for neoclassical economics which is the guiding light for mainstream economics taught to students today.

Neoclassical economics exerts a heavy hand in how a theory of the firm is configured in economics textbooks. Market prices are a function of supply and demand, and given perfect competition, will generate an equilibrium in which resources are efficiently allocated. In this stylized world, a firm transforms labor and capital inputs by way of its production cost function to yield outputs. Equilibrium is attained and profit maximized when marginal cost equals marginal revenue. In a world of complete information and perfect competition, no excess profits are possible. Oftentimes, the neoclassical definition of the firm is referred to as a “black box” since the firm is a mechanism to maintain mathematical logic of an economic system in equilibrium. Peter Klein summarize...