The Pragmatic Theory of the Firm

Abstract

Four key ideas provide the foundation for the pragmatic theory of the firm, which is expecially useful for managements and boards in developing an understanding of how companies create long‐term value for the benefit of all stakeholders.First, and a necessary point of departure, is clarity about the purpose of the firm. Maximizing shareholder value is viewed not as the social purpose of the firm, but as a consequence of a company's effectiveness in carrying out a purpose that recognizes the benefits of success to all key corporate stakeholders.Second, a company's knowledge‐building proficiency, in relation to that of its competitors, is viewed as the primary determinant of its long‐term performance. Nurturing and sustaining a knowledge‐building culture facilitates the discovery of obsolete assumptions and early adaptation to a changing environment.Third, the theory avoids “compartmentalizing” a company's activities into silos by treating the firm as a holistic system. A key component of the theory that quantifies corporate performance is the life‐cycle framework in which economic returns exhibit “competitive fade” over the long term. This holistic way of thinking provides insights about intangible assets and other sources of excess shareholder returns.Fourth, managing corporate risk should focus on identifying and removing all major obstacles to achieving the firm's purpose. Such obstacles can lead to value destruction through, for example, unethical behavior and all forms of shortsighted failure to recognize and make the most of opportunities to increase long‐run productivity and value.This theory of the firm is pragmatic in the sense that it aims to produce insights about a company's (or business unit's) performance that can improve management's decisions, especially in allocating capital and other corporate resources. The author uses John Deere's life‐cycle track record over the past 60 years to illustrate a successful application of the theory.