The Role of a CEO - Part I - Fundamental(s)

There is a great deal written about what a CEO is supposed to do. Most of it is either too tactical to be useful at the highest level or too vague to be useful at any level. Vision. Culture. Leadership. These words are not wrong, but they are downstream of something more basic. If you want to know what a CEO is actually being paid to do, it helps to start much further back, with three economists who, between them, explain why companies exist in the first place and what the person running one is responsible for.

I want to walk through their arguments in order. I think once you see them stacked together, the role becomes much harder to misread.

Ricardo and the Reason for Specialization

David Ricardo published his theory of comparative advantage in 1817. The standard example involves England and Portugal trading wine and cloth. Portugal, in Ricardo's example, can produce both more efficiently than England in absolute terms. The intuitive conclusion is that Portugal should produce both and England should produce neither. Ricardo showed that this is wrong. As long as Portugal's relative advantage in wine is greater than its relative advantage in cloth, both countries become wealthier if Portugal specializes in wine, England specializes in cloth, and they trade with one another.

The countries themselves are not really the point. The principle underneath the example is the point. Specialization, even imperfect specialization, generates more total output than self-sufficiency. A person, a firm, or a country that tries to do everything for itself will be poorer than one that concentrates on what it does relatively best and trades for the rest. This is one of the few claims in economics that has held up across two centuries of scrutiny.

That gives us the floor. Specialization creates wealth. The next question, naturally, is how specialization actually gets organized in the real world.

Smith and the Reason for the Firm

Adam Smith answered that question forty years before Ricardo, in 1776, though the logical order runs the other way around. His pin factory example in The Wealth of Nations is famous because it makes the abstract concrete. A single person, working alone, trying to draw, cut, sharpen, and finish a straight pin from raw wire, might produce twenty pins in a day. Ten workers, each performing one specialized step in sequence, produced what Smith estimated at forty-eight thousand. The output per worker increases by a factor of more than two hundred.

Something has to coordinate that arrangement. Markets coordinate trade between firms reasonably well, through prices and contracts and competition. But inside a firm, somebody has to decide who does what, in what order, with what equipment, for what wage. That coordinating structure is the company. The company exists because pure market exchange cannot, on its own, capture all of the gains available from sustained, organized specialization. Some activities are better organized under one roof, with one set of decisions, than they are through repeated arms-length transactions.

However a company describes itself in everyday language, its underlying function is structural. It is a vehicle for organizing specialization at a scale and consistency that markets alone cannot deliver. Whatever else a company does, that is what it is for.

Friedman and the Reason for the CEO

That brings us to the third question. If the firm exists to organize specialization, who runs it, and toward what end?

Milton Friedman addressed that question directly in 1970, in an essay that is much more often invoked than read — referred to as the Friedman Doctrine. The line everyone remembers is that the social responsibility of business is to increase its profits. What Friedman actually argued is more useful and less inflammatory than the soundbite suggests. The CEO of a public company, in his view, is an employee of the shareholders. The shareholders own the company. They have entrusted some of their capital to the CEO, and they have done so for a specific reason. They expect that capital to generate a return greater than what they could earn elsewhere on their own. The CEO's job is to deliver that return, within the bounds of law and basic ethical custom.

Friedman was not making a moral case for selfishness, and he was not arguing that companies should ignore their employees, customers, or communities. He was arguing that the way a CEO serves all of those constituencies, over time, is by running a profitable, durable enterprise. A company that does not generate returns for the people who funded it eventually stops existing, at which point it serves no one at all.

Taken plainly, Friedman is offering a job description. The CEO is the steward of capital that other people have provided. That stewardship is measured in returns, over time, against the cost of the capital itself.

Summary of the Fundamentals of the Role

Stack the three arguments together and the role of a CEO becomes clearer than any of them are alone.

Ricardo tells you that specialization is the engine of wealth creation. Smith tells you that the firm is the structure built to harness that engine. Friedman tells you that the CEO is the person responsible for making sure the structure delivers returns to the people who funded it.

This frame is useful mostly because it tells you what to ignore. A CEO who spends the bulk of their time on activities that do not, in some traceable way, improve the conversion of specialization into returns is not doing the job. They may be doing things that look like the job, and feel like the job, and are sometimes mistaken for the job by themselves and by their own boards. But the job underneath all of that is narrower and more demanding than most descriptions of it admit.

In a follow-up piece I will lay out how I think this rule plays out in daily practice, because the operating work of a CEO has, in my experience, a much simpler structure than the literature suggests. But the rule itself has to come first. Without it, every operating decision is up for negotiation. With it, most of them aren't.

The role of a CEO is the person responsible for converting — while simultaneously preserving, enhancing, growing, creating — a firm's specialized capabilities into compounding returns on the capital entrusted to the firm. Their job is to do everything and anything necessary to maximize per share value for shareholders. Every element of the role — culture, hiring, strategy, branding, operations — is in service of maximizing per share value.