Imperfect markets
S. Prakash Sethi
Business Ethics in Their Historical Context Concern about business ethics, or the lack thereof, seems to be a historical phenomenon that recurs with remarkable regularity through periods of prosperity and hard times. Yet the conventional wisdom has it that with some exceptions, most businesses are honest and law abiding. The challenge for us, however, is to find some explanatory and predictive variables that would help us understand why, and under what circumstances, corporations and their executives are prompted to engage in unethical and even illegal conduct. Equally important, this approach would provide a direction that we might take to contain these circumstances and thus curb unethical conduct.
The extensive prevailing literature in business ethics primarily views the issue in individual personal terms (i.e. corporate executive and the employee) and suggests that making corporations more ethical involves changes in executive behavior. While this approach has strong intellectual roots in moral philosophy and religion, it fails to explain the persistence of unethical and illegal behavior among corporations of all sizes, financial health, competitive market conditions, and level of individual executive compensation. As economic activity increases in complexity and technological orientation, it slips from its mooring in individual actions. Large scale eco nomic activity invariably requires collective action, where each individual contribution is connected, only remotely and indirectly, to the institution’s purpose as a whole. Thus, individual acts are rewarded and punished, not so much for their ethical content, but according to the notion of one’s loyalty and commitment to the institution’s success.
Business Ethics, Competitive Markets, and Industry Structure
To better understand the prevalence or lack of ethical conduct in business, we must look to prevailing industry structure and competitive dynamics in particular markets. Contrary to common beliefs, we assert that while highly competitive markets may promote efficiency, they do not guarantee ethical behavior and may indeed provide greater opportunities and incentives for unethical business behavior. Instead, it is the imperfect markets, with their above market profits, that provide the conditions that induce corporations to act both ethically and unethically, depending on the unique characteristics of those markets, and the corporation’s orientation in exploiting those characteristics for both good and evil.
Perfect competition and business ethics. ‘‘Competition keeps businesses honest.’’ If this were true, it would follow that firms would act more ethic ally, even in the economic sense of maximizing social welfare, as markets approximate the ideal conditions of perfect competition. Unfortunately, this is not the case when applied to business morality. While efficient markets may prompt firms to act smart, they do not induce them to act ethically, and, ‘‘ ‘perfect’ markets are highly imperfect in their enforcement of business morality’’ (Baumol, 1991: 24). The absolute discipline of ideal markets leaves little room for the individual firm to undertake voluntary activities that go beyond what is legally required. To do so would incur additional costs that a firm could not absorb, since buyers (being perfectly informed) would refuse to pay higher prices for products that could be bought more cheaply elsewhere.
Corporate structure and decision making processes. Large corporations and their decision making processes also militate against ethical standards. Group norms, and pressure to conform, exert strong influence on individuals to yield to demands for lower ethical standards when they are seen to be protecting the group at the cost of potential harm to ‘‘outsiders.’’ Corporate decisions, from conception to implementation, in volve hundreds and often thousands of individuals, each contributing an infinitesimal amount, and often with little or no understanding of its potential impact on the overall decision. The group orientation of corporate unethical behavior depersonalizes business leadership. The corporate personality diffuses the individual burden of guilt.
Imperfect Markets: Opportunities for Being Virtuous
There are two conditions – given the competitive nature of markets – that must exist in order to create a potentially conducive environment for business to behave ethically: (1) there must be some imperfections in the marketplace that the firm can exploit to generate ‘‘above normal’’ profits (i.e., strategic slack); (2) the firm must be assured of garnering both economic and non economic benefits from such ethical conduct in terms of greater customer loyalty, public good will and trust, employee satisfaction, and reduced government regulation and oversight, to name a few.
The existence of strategic slack is a necessary but not a sufficient condition for companies to act more ethically than their competitors. Although it provides the resources to enhance managerial discretion, it does not direct it. A company’s management may use its ‘‘slack’’ resources to enhance its ethical posture. It could just as easily use them to defy societal expectations and resist external pressures (Falbe and Sethi, 1989). Strategic slack affords management the arrogance of power to respond negatively to external forces of change. The ideological orientation of management may also influence its behavior by disregarding the needs of the general community and those stakeholders who cannot directly impact its operations (Baumol, 1991; Sethi, 1994; Sethi and Steidemeier, 1991).
The second necessary condition – market reward for a firm’s enhanced ethical and socially desirable behavior – is also rooted in market imperfections, especially as they relate to market concentration. A reputable firm inspires trust and confidence. Contrary to the conditions of ideal markets, the long term prosperity and growth of a company depends on its ability to engender customer loyalty and also propels it to deal with its stockholders, employees, and sup pliers in a fair and equitable manner. A similar approach toward the community at large augurs well for maintaining a high level of sociopolitical trust and puts high value on ethical and socially responsible behavior as an integral part of doing business and corporate ethos (Baumol, 1991; Heal, 1976; Sethi, 1994). It behooves the firm to sacrifice at least some of its short term profits arising out of market imperfections and use them to build greater entry barriers against competitors and ensure long term, above normal profit ability.
Imperfect Markets and Impediments to Being Virtuous
Imperfect markets have become a dominant condition and are likely to remain so for the foresee able future. This raises an important question: How can the large corporation be induced to act ethically and socially proactively, without the burden of onerous governmental regulation and oversight, and minimize the cost of regulatory failure?
In one sense, society’s moral and ethical values are public goods. All members of a society stand to benefit from their enhancement, regard less of their individual contribution. This may partially explain the inherent discrepancy in public trust and goodwill enjoyed by non governmental organizations (NGOs) against that of the business community.
Profits are one measure of a corporation’s reward for doing its job well. In this sense, the most profitable corporation is also the most socially responsible corporation and doesn’t need to do anything else (Friedman, 1970). The problem of the free rider does not exist (Sethi, 1994), since private firms must always try to maximize private gains by internalizing all possible profits and externalizing all possible costs.
Under conditions of imperfect markets, dominant firms cannot always control – for legal and other reasons – the behavior of rogue firms wishing to exploit an industry’s stock of public trust for their own gain (i.e., become a free rider). This condition is likely to be exacerbated where public trust in an industry or a firm’s integrity is high. Industry members, therefore, must assume that other companies would follow suit and behave equally aggressively as free riders, since they have more to lose from con tributing to general public trust and moral and ethical values and everything to gain from being a free rider. On the other hand, where industry standards of ethical norms are low, and so perceived by the public at large, deviance by an industry member to raise ethical standards and undermine industry’s public stance would be severely resisted by the rest of the industry, with the deviant member subjected to intense public and private pressure to fall in line.
The one exception to this rule would take place where a firm’s market position and resultant non market rent are so strong that it must protect them at all costs by courting the goodwill of its customers, government regulators, and the public at large (Hirsch, 1976; Schelling, 1978). The incentive to do so, however, is not altruism, but a desire to preserve profits. This condition tends to undermine the value of a firm’s contributions to enhancing society’s stock of ethical and moral values because the company is viewed to be primarily acting in self interest. By linking their good corporate citizenship activities to specific constituencies that enhance the business goals of the corporations, called ‘‘strategic giving,’’ companies dilute their social import and the altruistic character of their ‘‘public or collective goods.’’
A third problem pertaining to companies’ reluctance to pursue higher ethical standards is related to the authority and power of top man agers within the organization structure; the nature of their rewards – financial and non financial, private and social; the reference group to which these managers aspire to belong; and how these managers view themselves and are in turn viewed by society. Received legal theory and corporate hyperbole suggest that a company’s managers work primarily to enhance the best interests of the firm’s owners (i.e., stock holders), commensurate with some measure of acceptable risk. However, in practice this is far from true, as recent incidents of corporate fraud (e.g., Enron, WorldCom, Tyco) amply demonstrate. It is in the interest of corporate managers to perpetuate such a myth to protect their authority and power. Top managers hold most of the cards in controlling the destiny of the corporation and, except in dire circumstances, are hard to replace by discontented stockholders (Bolton, 1993; Loomis, 1993). The gap between the rhetoric of CEO accountability to shareholders and the reality of CEO and top management has caused a crisis in corporate governance, leading to the enactment of the Sarbanes Oxley Act of 2002.
Altruism as a Desirable Institutional and Personal Goal
It would seem counter intuitive to suggest that economic institutions could ever be made to seek altruistic goals as an integral part of their overall objectives. Yet this is precisely what needs to be done. An important characteristic of the Ameri can sociopolitical system is that most corporate leaders do not come from established social elites. Nor do they have recognized symbols of social class, such as titles. The public at large has little familiarity with their individual personalities and character, and colors them with the same brush as the corporation they manage. Devoid of mutual trust, people use political processes to impose rigid conditions on corporate behavior. Managers respond in kind by satisfying the form of the law and legal requirements without concerning themselves with the sub stance or objectives for which those requirements were imposed.
For corporate managers to act beyond the minimally prescribed and legally enforced norms of social conduct, it would be important to foster mechanisms for generating a higher threshold level of trust. This necessitates a redefinition of the successful corporation and the character of its leadership. Through social consensus, akin to that of other societal institutions (e.g., universities and churches), the highly admired and trusted corporation would display the dual characteristics of the financially successful enterprise with equally good corporate citizenship, defined in terms of corporate behavior that uses its economic power with self restraint and strives toward distributive justice for other factors of production in relation to their contribution to the success of the enterprise.
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