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Unformatted text preview: Business Ethics in a Competitive Market“ juliamze Nelson ** ABSTRACT. Consequentialist reasoning and neoclassical assumptions about perfectly competitive markets encourage business school faculty and students to overlook the role of ethics in a market system. In a perfectly compedtive economy, self-interest suffices to bring abour a desirable outcome. However, discrepancies between an economist‘s assumptions and the realities of a market economy establish a need for business ethics. This essay. written as a lecture for MBA students, first reviews Pareto optimality as an argu- ment in favor of market allocations. lt then uses the discrepancies between actual and hypothetical markets to derive a Rawlsian duty of civility. This neoclassical case for business ethics requires individuals to avoid exploiting the defects that are inevitable in any social Structure. Introduction Where do you find an argument for business ethics? We know that the term “ethics” rarely appears in the index of standard texts on finance or economics. In this essay, I develop the case for business ethics that belongs in these texts. My argument unfolds as follows: 1 first sketch a proof for the familiar proposition that voluntary trades lead to an outcome which is Pareto optimal relative to the initial specifi- cation of endowments. i then list some of the discrepancies between reality and the assumptions underlying the proof of Pareto optimality. These julianne Nelson is an Assistant Majessor of justice at the School 9/. Public Aflhirs in the American University in Washington, DC. She has also taught at the Stern Sclwol of Business of the New York University and at the Ecole Superieure de Commerce in Tours, France. Her publira'rjom‘ have appeared in the International Economic Review, Economics Letters. The journal of Regulatory Economics. japan and the World Economy. The Journal of Business Ethics and Economics and Philosophy. differences provide the foundation for my neo- classical case for business ethics: I argue (along with Rawls) that managers have a duty to uphold the system rather than exploit its inevitable loopholes. The merits of perfect competition Economists typically state the moral case for a market system in a single sentence: All competitive equilibria are Pareto optical. This sentence captures a simple, elegant, and power- ful argument: If we use the gratification of indi— vidual desires as our standard for judging a system, then no one can improve upon the outcome of self- interested market activity. 50 who needs business ethics? To find out, let us examine the argument behind the sentence. The proof of the assertion that all competitive equililiria are Pareto optimal starts with a handful of seemingly innocuous assumptions: (1) We are all endowed with specific rights. resources. and abilities. (2) We are economically rational (in, producers maximize profit and consumers maximize utility). (3) We all behave competitively in both spot and futures markets (La, neither producers not consumers expect to influence the prices of goods and services offered for sale). (4) We all have the same information. (5) We do not use technologies that cause exter— nalities or that exhibit increasing returns to scale at relevant levels of production. (6) We. consume only private goods (i.e.. there are no public goods in the economy). (7) We allow anyone to start up a business on the journal of Business Ethics 13: 663—066, 1994. C) 1994 Kl tuner Academic Publishers. Printed in the Netherlands. 664 Julianne Nelson same terms as existing producers; we allow any existing producer to shut down opera— tions at will (i.e., actual and potential pro- ducers enjoy “free entry and exit”). Any economy that satisfies these assumptions we label “perfectly competitive.” Consider now the aftermath of costless trading in such an economy. By definition, trading stops when, for each good and each service, supply equals demand at market prices. In this competitive equi— librium, past trades will have determined prices for all goods and services to be delivered now and in the future (remember the competitive futures marketl). Consumers will have gone home, convinced that they can do no better at market prices. Producers will have gone home unable to generate additional profit at market prices. How do we characterize this situation? Clearly all trades that are mutually beneficial at market prices have already occurred. If they had not, some people would still be left in the market; we would not yet be in equilibrium. Therefore, if any trade does occur it will harm at least one individual. In other words, the Competitive equilibrium must be Pareto optimal: no one can be made better off without making someone else worse off.‘ I What, then, is the moral case for the market? If you judge the system (perfect competition) on the basis of its results (Pareto optimality), you find that there is no room for improvement. Neither man- dated trades nor an express concern for other members of society can improve upon the outcome of a perfectly competitive market. Sen, among others, argues that any moral case for a market necessarily has this structure.2 Witness the power and the scope of this rationale: in a perfectly competitive economy, government regu- lation is necessarily wasteful and coercive, while the conscious practice of business ethics serves no social propose. Gauthier carries this line of reasoning to its logical conclusion, arguing that perfectly competi- tive markets are “morally free zones.”3 Perfect competition and the real world Is there a flaw in this line of reasoning? In general, the best way to evaluate an argument is first to examine its structure for errors in logic and then to analyze its assumptions. There is little hope of finding a logical flaw in the argument that all competitive equilibri‘a are Pareto optical: proofs of different versions helped earn Nobel prizes for Arrow and Debreu, while the statement itself has come to be known as the “fundamental theorem” of welfare economics. We therefore proceed to the assumptions. The assumptions listed earlier raise two obvious questions: “How well does the world satisfy the textbook definition of perfect competition?” and “Is equilibrium still Pareto optimal if existing markets are not perfectly competitive?” To answer these questions we review our “seemingly innocuous” assumptions. One method of testing the strength of an assump- tion is to list the conditions and circumstances that it rules out. For example, by asserting that endow— ments “are given,” we avoid a variety of messy situations. In a perfectly competitive economy, property is never held in common; property rights never overlap. Since all assets are initially allocated to some member of society, no questions of legal ownership or responsibility ever arise. Since endow- ments are costlessly enforceable, no resources need be wasted on protection. Since we essentially rule out any distinction between possession and owner— ship, we never encounter questions of agency or fiduciary responsibility. Finally, by accepting the arbitrary initial distribution of rights, wealth and abilities, we banish questions of fairness and elimi- nate any duty of charity. By assuming economic rationality, we rule out inconsistent trade-offs and altruism. Choices never bewilder consumers. Since utility maximization pre- supposes consumers with well—defined tastes, adver— tising has no role in shaping preferences. By assuming competitive behavior, we deny the existence of strategic behavior. No market leader acts on the belief that it can set industry price or quality standards. No dominant fim assumes that it can intimidatedvals, either new or old. In a perfectly competitive economy, no one ever takes advantage of a superior bargaining position as a buyer, seller, employer, worker, or contractor. If we all have the same (but not necessarily perfect) information, the seller never knows more than the buyer about the quality of a product; Business Ethics in a Competitive Market 665 hunting never produces a bargain; the employer never knows more than the employee about work— place safety", and the broker never knows more than the customer about the quality of a recommended investment. If there are no externalities (i.e., if ownership claims are costlessly enforceable), then environ— mental pollution never occurs without the consent of those holding title to the land, air or water in question. If there are no transaction costs, then neither real estate agents nor Stockbrokers ever receive a com— mission. Unless reality satisfies these and the other as- sumptions listed, we cannot be certain that market allocations are Pareto optimal. It follows that busi— ness ethics and collective action would have a place in the conventional argument for free markets if these actions promoted Pareto optimality. A neoclassical case for ethics We see that reality may diverge substantially from the assumptions that form the basis of the moral case for a market system. We must therefore ask, “What role remains for business ethics?” Rawls has derived a “duty of civility” from the unavoidable defects in any social structure: . . . we have a natural duty of civility not . . . to exploit the inevitable loopholes [in social arrangements] to advance our interests. The duty of civility imposes a due acceptance of the defects of institutions and a certain restraint in taking advantage of them. Without some recognition of this duty, mutual trust and confidence are liable to break down.‘ I claim that the discrepancy between hypothetical and existing markets implies a duty of civility for anyone wishing to make a principled argument for capitalism. To deny this duty is to deny the validity of the initial allocation of rights, of essentially to contradict the assumptions that provide the logical basis for a market system. In other words, to deny this duty is to undermine the moral foundation of the market system. To derive the extent of these ethical obligations, I first characterize the nontradeable rights that are necessarily included in individual endowments. I then reason that each person has the duty to support the system by acting in a manner consistent with its assumptions. In a market economy, any specification of per- sonal endowments must include some version of the following assumptions: (1) Individuals have an inalienable right to own property. (2) Individuals have an inalienable right to enter into voluntary trades. Note that the first assumption is not a right to a specific asset, merely the right to retain the property in one’s possession. The second assumption prevents individuals from selling their right to participate in the market. Clearly this list of assumptions could be expanded to include other rights, such as the right to survival. These two assumptions, however, are suffi- cient to make my point. In each case, these rights are an intrinsic characteristic of citizenship. With Okun, I assume that individuals can neither buy nor sell these rights and that these rights are uniformly distributed in the population.5 I now claim that in a market economy, each individual has a duty to maintain the system. The strong form of this argument requires of individuals an affirmative duty to eliminate the discrepancies between real and hypothetical markets. A weaker form of this argument insists that individuals avoid exploiting these discrepancies. To refuse to acknowl— edge some duty to support the system is to under— mine the moral case for a market system: if the assumptions do not hold, the “fundamental theo— rem” of welfare economics does not follow. You cannot rely on conventional arguments about Pareto optimality to assert that capitalism leads to some morally superior outcome. Business ethics in practice What particular obligations does this duty of civility imply? It does require more than mechanical obedi— ence to the law. In general, this duty would include an obligation not to abuse market power and gener- ally not to manipulate the system. A few examples help illustrate the practice of this form of business ethics. An individual’s right to own personal property 666 julianne Nelson and the assumption of symmetric information to- gether give rise to a fiduciary duty to the unin— formed. In particular, one individual’s superior information should not be used to deprive another of the value of personal property, particularly when the uninformed individual faces a relatively higher cost of acquiring equivalent information. This logic would proscribe insider trading. It would require an informed seller to notify a buyer of hidden product defects and force an expert buyer to provide an honest appraisal of goods proffered by an unin— formed seller. Other instances of a duty of civility in this context include an obligation to promote accu— rate and informative advertising as well as the responsibility to see that contract conditions are understood by all parties. If an individual’s endowment included a right to survival, then the duty of civility would require that a company’s bargaining power not be used to force workers to accept hazardous working conditions. A strong version of a worker’s right to survival would in fact suggest that an employer takes the initiative to improve dangerous working condin’ons. Conclusion My proposal is designed as an extension of the argument developed at the beginning of this article to support competitive equilibria; it is intended to force managers to consider explicitly the endowment granted to each individual in society. This proposal implies that a principled argument in support of capitalism requires more than mechanical observ- ance of the law. Court costs and legal standards of proof make it possible to infringe upon the rights of others without being forced to bay compensation. In my argument for business ethics, I ask that managers avoid taking advantage of such opportunities. The practice of business ethics cannot be limited to those activities which enhance profits and/ or company reputation. The cases mentioned in the last section make it clear that the practice of ethics often implies foregoing some profitable opportunities. I call upon each manager to honor these ethical obligations even if colleagues do not. While it may be the case that no single manager has the incentive to behave in the manner I suggest, it is also the case that if all managers follow the prescribed agenda, the outcome of a market system would have a better chance of being Pareto optimal. My proposal admittedly represents a narrow case for business ethics. A broader role for business ethics could be found in the answers to other questions: “How fair is the initial distribution of wealth and property?” or “Should everything be for sale?” For the moment, a more limited focus suffices. The actions called for here are difficult enough. Notes " Editorial note: Date of acceptance July 4, 1991. This article follows the article published in Volume 11 (4), pp. 3 1 7—3 20. ' My thanks go to Tom Donaldson, Bob Lindsay and Kerry Whitesidc for their helpful comments on earlier versions of this work This research was supported by a grant from the Rundin Foundation ‘ For a more formal version of this proof by contradiction, see Varian, H.: 1984, Microeconomic Analysis, 2nd ed. (Norton, New York), p. 200, or Feldman, A: ‘Welfare Economics’, The New PalgraveA Dictionary quconomics, vol. 4, pp. 889—891. 2 Sen, A. K.: ‘The Moral Standing of the Market’, in E. R. Paul, F. D. Miller and J. Paul, eds., Ethics and Economics (Blackwell, Oxford), p. 17. . 3 See Morals by Agreement: ~1986 (Oxford University Press). Daniel Hausman provides a critical overview of Gauthier’s argument in ‘Are Markets Morally Free Zones?’, Philosophy and PublicAfizirs, VoL 18, No. 4 (Fall 1989). ‘ Rawls, J.: 1971, A Theory of justice (Harvard University Press, Cambridge), p. 355. 5 Okun, A. M.: 1975, Equality and Eficiency: The B12 Tradeofl (Brookings, Washington, DC), pp. 6—9. American University, School of Public Aflhirs, Washington, DC, 20016-8043, USA. ...
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