1 The Ethical Norm in Economics and the Theory of the Firm
Ethical norms pose our aspirations. We often pose them as aspirational virtues for the individual, and we also apply them as standards for our society. We use our moral norms to analyze our social institutions, to perceive their defects and their possible paths of improvements. For example, the classical economics of Adam Smith’s Wealth of Nations (1776), David Ricardo’s On the Principles of Political Economy (1817), Thomas Malthus’ Essay on the Principle of Population (1826), and John Stuart Mill’s The Principles of Political Economy (1848) argued a social norm against government interference in the economy. The neoclassical economics of Alfred Marshall’s Principles of Economics (1890) emphasized the functioning of markets and a “price theory” for rationing society’s resources in production and consumption. This also posed a social norm. We can claim this because at its heart, neoclassical economics emphasized individual “utility maximization” for explaining individualistic behaviors. 1 That implicitly feeds the philosophy of the individual’s “freedom to choose.” 2
The neoclassical economic model also posed societal norms for governmental interference when certain market failures occurred, failures such as negative externalities (pollution) or monopolies. Neoclassical economics also posed the norm of the perfectly competitive market, the perfectly competitive firm, and regulated monopoly. The efficiencies of each vision were analyzed, but the perfect competition model seldom applies empirically to any particular industry, and neither does the model of monopoly. 3 The two extremes are analyzed in economics, and we do pose the competitive model as having moral dimensions applicable to aspects of social efficiency .
The neoclassical analysis concerned free individuals getting the maximum from their efforts within resource constraints. The combination of individuals being free from government interference , plus the neoclassical notion of “economic efficiency,” were emphasized. 4
This perfect competition model of neoclassical economics extends from the foundation of classical economics as reviewed above. It poses the following as interrelated advantages of competitive markets:
- The Freedom Advantage: This advantage depends on individuals being free to move to the occupation they wish and producers being free to enter markets when they perceive possible advantages.
- The Efficiency Advantage: Through the market process, the competitive firm was perceived as assuring that goods are produced at minimum average cost including a minimum acceptable return to the producers which is just enough so that they keep producing in that market. Competition also was perceived as assuring a minimum acceptable distribution to employees, i.e., enough to keep them likewise engaged. Consumers were then able to purchase at these minimum-competitive prices. This provides a resource-rationing system with a type of economic efficiency that assures that the goods society desires are provided at minimum social costs. But this assumes that all costs of production are internalized to the production process, i.e., that there are no negative externalities such as pollution. 5
- The Social Welfare Advantage: Assuming that social welfare can be measured as the sum of all individual utility levels, then the competitive market process (without externalities) maximizes social welfare. By this, it is meant that resources are rationed by the “market price system” so that consumers get the goods they desire at a minimum cost, and employees move to their preferred occupation at an acceptable compensation . 6
It must be emphasized that the three categories of advantages are considered interrelated in that social welfare maximization fails without either freedom or efficiency. Efficiency was also considered as not achievable without freedom to move from one market to another. In this sense, social welfare followed from freedom and efficiency in competitive production. In a general sense, it should be obvious that there exist some ethical implications posed by the neoclassical competitive economic model, but as such these implications are in need of exploration and clear specification.
The neoclassical model depends on individuals being egoistic utility maximizers as consumers and producers. It also depends on producers being profit maximizers. 7 People, of course, might and probably do have interrelated preferences in that what they prefer in an individual setting might differ from what they prefer in a group setting, i.e., your happiness may depend on the well-being of many others. The existence of interrelated preferences implies that competitive markets might need collective regulation to be social welfare maximizing. 8 For example, some degree of income redistribution might be warranted.
Markets might also not be perfectly competitive. Considering this, the neoclassical firm is generally juxtaposed against monopoly for which production is lower and market price higher. Consumers are therefore deprived as compared to competition. In this sense, compared with a monopoly the competitive model poses a norm, a sort of minimalist moral model of an economic system that serves social welfare.
The neoclassical competitive model does have some empirical capability for describing some markets, such as some agricultural markets. It can also indicate the defects of monopoly and pose regulatory controls to counteract these defects. The point is that the norm posed by the neoclassical model of perfect competition allows us to analyze the situation of monopoly and to perceive its defects. This norm may be abstract and only pose society’s aspirations for an economy, but it allows analysis of the social shortcomings of deviations from perfect competition, and it provides directions for possible remedies. This norm is not intended to be entirely realistic, but to give directions for analysis and social aspirations. The same is true for our moral norms such as those against business fraud. We know the norm is not a perfectly accurate description of society, but it allows analysis of unacceptable behavior and its negative effects on society.
Market philosophers have long argued about “the Adam Smith problem,” i.e., the seemingly apparent contradiction between Adam Smith’s ethical philosophy as expressed in The Theory of Moral Sentiments (1759), and the egoistic agent of the invisible hand as expressed in Wealth of Nations (1776). In attempting to resolve this apparent conflict, Samuel Fleischacker (2004, p. 91) argued that “human beings can pursue even their individual interests together, that even society without benevolence need not be a hostile society, that economic exchange, even among entirely self-interested people is not a zero-sum game.” More recently, Mark White (2011, pp. 114–115) argued that in the Wealth of Nations, Smith did not make an argument in favor of egoism, although he did show that pursuit of self-interest might be sufficient for a hypothetical economic flourishing. Smith only argued that because agents knew their own self-interests, the economic philosophy of mercantilism was inefficient by its nature, i.e., that markets can operate based on self-interest, not that they strictly should operate in this way. The moral behavior of participants still determines whether markets are hostile to society’s interests and also the extent of this hostility.
The neoclassical economic model appears to pose individuals as egoistic utility and profit maximizers without altruistic or other ethical motives. The “other ethical motives” were not introduced because the classical and neoclassical authors pursued analyses of a narrow notion of efficiency , one that is considerably extended in this monograph. This “extension” is explored and illustrated in Chapters 8 and 9.
As an addition to the neoclassical view, however, the nexus of contracts theory of the firm was offered by Coase (1937) and developed by Alchian and Demsetz (1972), and Jensen and Meckling (1976) (See Chapter 3). This theory views management as pursuing a set of interlocking perfect duties (obligations th...