The Puzzled Regulator: The Missing Link in Our Understanding of Social Enterprises

This is part of a series of think pieces by scholars and practitioners working on a broad range of issues within the field of Social and Solidarity Economy. The series is being published in conjunction with the UNRISD conference “Potential and Limits of Social and Solidarity Economy”. The conference took place on 6-8 May 2013 in collaboration with the International Labour Organization and the UN Non-Governmental Liaison Service.

The lack of a well-defined business model is a major obstacle for a successful regulation of social enterprises. Current regulation efforts, while valuable, have largely ignored early research in sectors where the first social enterprises emerged. Such a business model is becoming more of a necessity than a normative proposal because in an era of austerity-stricken public finances, social enterprises must find a way to outperform for-profits competing in markets with blurred sectoral boundaries. This piece looks into a more precise definition of the social enterprise business model, which has surprising implications for the potential transformation of the third sector and its impact on market economies. The piece also challenges the misperception of social enterprises as either donative not-for-profits with commercial arms or for-profit ventures.

Dr. Alejandro Agafonow is based in France as an Assistant Professor of Economics at ESSCA School of Management and its Centre for Expertise and Research in Social and Solidarity-Based Economics (CeRESS). He is currently developing an economic theory of social enterprises.

Introduction

The regulation of for-profits relies today on a large body of economic knowledge to understand the problems that market failures are likely to produce in an unregulated economy. This body of knowledge, while considerable, can for our purposes be boiled down to a single building block: the notion that for-profits tend to extend their operations until the difference between total revenue and total cost is roughly maximized. The problem with profit maximization is that in the presence of market failures, it is likely to trigger some of the most pressing issues that concern us today, like monopolization and damage to the environment. The regulator’s role is to tackle some of these difficulties. But the emergence of social enterprises has proved puzzling for regulators, whose reference book does not include the possibility that social enterprises might compete directly with for-profits.

In the European Union, a response has come in the form of new regulations crafted with the help of social economy experts. These regulations include rules that favour social enterprises in public procurement processes, favourable treatment of social enterprises supplying services of general economic interest, and corporate revenue tax exemptions at the discretion of member States. While these measures represent a leap forward, I am afraid they may fall short of their goal for a very simple reason. The above-mentioned building block for for-profits is without parallel in the emerging social enterprise sector, as the social enterprise business model has yet to be fleshed out. Fortunately, scholars have made some progress in this direction. Borzaga and Tortia (2007), for instance, have documented how social enterprises are moving away from the traditional third sector advocacy and redistributive roles toward a more productive role in which they market goods and services. Porter and Kramer (2011) have developed the idea of “shared value” in order to assert that profit coupled with societal benefit is a higher form of profit. Finally, Dees and Anderson (2003) and Mair and Martí (2006) advocate the advantages of combining social ventures and profit aims.

However valuable these contributions are, they have overlooked early research into sectors where the first social enterprises emerged. To be sure, this research is neither extensive nor on the whole enthusiastic about the economic consequences of a business strategy that does not conform to neoclassical standards. This research points to the way business affairs are carried out in, for instance, the non-profit health service sector and the performing arts, where evidence indicates that output, not profit, is maximized according to a predetermined level of quality (i.e. the higher the quality, the higher the cost of production as well as prices charged to clients). This is consistent with the business practice that Yunus (2010) has deemed essential to a financially sustainable departure from profit maximization in the microfinance industry, namely, when a social enterprise (a social business type I in Yunus’ terminology) devotes surpluses to the expansion of business itself, widening its outreach to serve a larger clientele.

Social enterprises’ missing link

Here we are confronted with the dilemma of every emerging general theory: The higher the level of abstraction needed to achieve parsimony (that is, using the fewest possible assumptions) and predictive capacity, the higher the pressure to dispense with anecdotal accounts and inessential data that today fuel the analysis of social and solidarity economy. Certainly, the law of parsimony has been abused in twentieth-century neoclassical economics’ fixation with mathematization, where everything was boiled down to assumptions so simple as to verge on the nonsensical. For social and solidarity economy, it is imperative to preserve contributions achieved within the neoclassical research agenda that have universal scientific value, thus avoiding throwing the baby out with the bathwater. Building on these contributions will enable us to bring to light social enterprises’ business model, which I spell out below.

In Figure 1, I show the economic rationale behind a for-profit enterprise compared to a social enterprise that maximizes social benefit. The upper part of the figure depicts total cost and total revenue curves, and the lower part depicts marginal cost (MC), average total cost (ATC) and average variable cost (AVC) curves. MC represents the cost of one more unit of output compared to how much it cost to produce all output so far; ATC is the total cost per unit of output; AVC is the average cost that changes depending on how many units of output are being produced (without considering fixed costs). Both firms have the same curves, assuming the same productive activity and technology; the difference lies in their mode of operation, manifested in the position along these curves they are likely to have after a certain time of operation.

Operating in the real-world institutional background of imperfect markets, for-profit firms tend to maximize the excess of revenues over costs (shown in the upper part, left-hand side of Figure 1) when the space between the total cost curve and total revenue is at its maximum. If a for-profit succeeds in profit maximization, it reaches a point where its marginal cost (mc is a single point along MC) of producing an additional unit of output is equal to the marginal revenue (mr) gained from selling that output, represented by point 2 along the MC curve. To achieve this, a for-profit prices output according to the highest price attainable in the market. Since perfect competition does not exist, price is not driven down to the point where the cost of production roughly equals the selling price, which is represented by the MC curve intersecting from below the ATC curve at its minimum point. Indeed, profit maximization in an imperfect market requires the price to be somewhere above that intersection, as shown by point 2. This is a scenario that regulators are normally concerned to prevent, because under certain conditions it is likely to degenerate into monopolization where consumers are exploited, potential competitors are excluded and contrived scarcities are triggered, keeping resources underutilized.

In contrast, a social enterprise uses a different pricing method. It charges consumers a price low enough to foster the inclusion of marginalized consumers but high enough to produce a surplus that will be devoted to the expansion of production, hence adjusting revenues to cover costs until any potential profit is eliminated after a certain period of operation. This pricing method achieves something very different from the outcomes of for-profit enterprises. Operating in imperfect markets, social enterprises tend to increase sales until the space between the total cost curve and the total revenue curve is at a minimum, as depicted by the point labelled “minimum profit” in the upper part, right-hand side of Figure 1. If they successfully cater to consumers, social enterprises reach a point where the ATC of producing a given amount of output is equal to the mr gained by selling that output, represented by the starred point 1 along the ATC curve.

This enables a social enterprise to produce a larger output Omax on the figure at the same price level, compared to the line labelled Omin in the for-profit model. This is possible because the social enterprise model is built around putting profit back into expanding production by the amount represented in the grey triangle. Social enterprises can thereby move into markets overlooked by for-profits, because the mc of producing an additional unit of output is higher than the mr gained by selling that output until profit is finally exhausted and yet total costs are covered. Looking at it the other way around, while a monopolist may increase the price until point 1’ along the MC curve, social enterprises are able to sell the same output Omax at the more affordable price of the starred point 1.

In short, a social enterprise is expected to operate in the proximity of the ATC curve, where mc is higher than mr, until profit reaches a minimum. A social enterprise is able to produce a larger output Omax at the same price level, compared to Omin in the for-profit model. Put the other way around, while a for-profit firm may increase the price until point 1’ along the MC curve aiming at profit maximization, a social enterprise can sell the same output Omax at the more affordable price of the starred point 1 aiming at output maximization (Agafonow, 2012). Therefore, for the purposes of regulation, I propose defining a social enterprise as one built around the principle of pricing goods according to their average total cost of production, and giving back to poor consumers as much surplus as economically feasible.

Toward an economic theory of social enterprises

The social enterprise business model has yet to be thoroughly outlined in the academic literature. In the mid-twentieth century, scholars proposed a model that lay in between the points of maximum and minimum profits. They pointed out that some CEOs were venturing into the market at a suboptimal output level—in the profit-making sense—somewhere between Omin and Omax, while however complying with a minimum profit constraint imposed by stockholders. It is easy to see why this so-called sales revenue maximization hypothesis was largely ignored, as it effectively claimed that the interests of large US corporations were more aligned with the public than with stockholder dividends. The potential conflict of interest between managers and stockholders in large corporations is well-known in the management literature, but it is little wonder that the notion of for-profit large corporations voluntarily relinquishing market power for society’s sake was deemed unpalatable. After all, it would have to be explained why stockholders did not make use of their power to replace CEOs in the first place.

The future implications of this new proposed definition of social enterprise are no less than the potential transformation of the third sector and its impact on market economies. The proposed new definition may have some difficulties being accepted by the scholarly community because there is lots of confusion about the much vaunted blending of social missions and financial goals, as well as a strong redistribution bias showing a general lack of imaginative, financially sustainable alternatives. Below I offer some hypotheses that shape my research agenda, although collaboration will be essential if it is to come to fruition:

1. Social enterprises have a natural advantage over for-profit enterprises, in that given the same managerial capabilities and resources, social enterprises are more likely to become resilient price competitors.
2. If social enterprises are to become a way out of the financial strains faced by the welfare state, the business model outlined here offers a financially sustainable alternative to both profit-maximization and donative not-for-profits.
3. The “redistributive” and “productive” roles of social enterprises are far more coherently defined and represented by the grey triangle in Figure 1 than in anything the scholarly literature has produced so far. In more technical jargon, social enterprises achieve financial sustainability while redistributing resources by taking the marginal cost of producing an additional unit of output above the marginal revenue gained by selling that output, giving back to poor consumers as much surplus as economically possible.
4. The definition of social enterprises submitted here challenges the idea that they are donative not-for-profits with commercial arms which engage in the production of non-excludable goods that cannot be marketed while appealing to consumers’ self-discrimination to buy from their profit-maximizing divisions.
5. Donative not-for-profits can, however, operate along the lines of a social enterprise if access to subsidies is carried out on a competitive basis by means of quasi-markets.

Although policy implication cannot be easily summarized in this piece, it is worth mentioning that the business model outlined here invites a rethink on how to regulate the accumulation of market power in the emerging social enterprise sector. Since the traditional value appropriation strategies of for-profits are being given up by social enterprises for the sake of increasing consumer surplus, regulators’ standard views on consumer exploitation must be revamped. Also, this business model suggests that while social enterprises have an advantage over for-profits in terms of price competition, they also have inherent limits in terms of dividend distribution that constitute a barrier for financing. Superior price competition must be balanced against financing barriers to advise on more effective regulatory policies for social enterprises.

Reflections

It remains to be explained why this business model is more of a real necessity than a normative proposal that social entrepreneurs can dispense with should they find it unpalatable. This fuller explanation is equivalent to the general theory of for-profits that has shaped economic theory over the last centuries, and it is beyond the scope of this think piece to consider. However, as a matter for reflection, I suggest that just as for-profits are forced to maximize profits to avoid being driven out of business by competitors aiming to serve consumers more effectively, in a time of austerity-stricken public finances social enterprises are increasingly being forced to maximize output in order to increase their chances of fulfilling their social mission in the presence of for-profits trying to reap the benefits of markets that were negligible at other times.

REFERENCES

Agafonow, A., 2012. “Social Business: The Non-dividend Side of the Equation.” Paper prepared for 4th International Social Innovation Research Conference.Third Sector Research Centre, University of Birmingham, United Kingdom, 12-14 September.

Borzaga C., and E. Tortia, 2007. “Social Economy Organizations in the Theory of the Firm.” In A. Noya and E. Clarence, (eds).The Social Economy: Building Inclusive Economies. OECD, Paris.

Dees, G., and B.B. Anderson, 2003. “For-Profit Social Ventures.” International Journal of Entrepreneurship Education, Vol. 2, No.1, pp. 1-26.

Mair, J., and I. Martí, 2006. “Social Entrepreneurship Research: A Source of Explanation, Prediction, and Delight.” Journal of World Business, Vol. 41, No. 1, pp. 36-44.

Porter, E.M., and M.R. Kramer, 2011. “Creating Shared Value.” Harvard Business Review, Vol. 89, No. 1/2, pp. 01-17.

Yunus, M., 2010. Building social business:The new kind of capitalism that serves humanity’s most pressing needs, Public Affairs, New York.