Fairness, character, and efficiency in firms.

• Jurisdiction: United States
• Date: 01 June 2001
• Author: Cooter, Robert

In the middling and inferior stations of life, the road to virtue and that to fortune, to such fortune, at least, as men in such stations can reasonably expect to acquire, are, happily in most cases, very nearly the same. In all the middling and inferior professions, real and solid professional abilities, joined to prudent, just, firm, and temperate conduct, can very seldom fail of success.

--Adam Smith(1)

INTRODUCTION

What forces shape the conduct of individuals and firms? Legal scholars traditionally focused on the explicit content of the directions that legal rules give to people. Within the last twenty-five years, however, law-and-economics scholars have shifted the focus from explicit directions to the implicit incentives created by legal rules. Within the last ten years, both lawyers and law-and-economics scholars have turned their attention to the interaction between legal rules and nonlegal norms. This recent discussion mostly concerns the norms of large social groups, such as the general society, merchant communities, ethnic groups, or the corporate community. We call norms of this type general social norms. In contrast, this Article concerns norms that are specific to firms: in particular, firm-specific fairness norms.

We advance two theses: First, firm-specific fairness norms typically promote efficiency. Second, firm-specific fairness norms best promote efficiency when supported by reputation effects and when the firm's agents internalize the norms. Internalized norms become part of an agent's character. We will develop the concept of good agent character, by which we mean agent character that serves the firm's profitability by embodying the firm's fairness norms. This neglected topic helps explain how firms work and why they exist.

1. DEFINITIONAL ISSUES

   We begin with the issue, what constitutes a norm. A common approach to this issue is to define norms as unofficial standards of conduct. We call this type of definition standards-based.

   Standards-based definitions are unduly exclusive, because in ordinary language the term "norm" encompasses regularities that are not standards, such as the practice of directors, prior to the 1990s, to exercise only limited diligence.(2) Violating a standard of behavior typically provokes criticism by others, whereas departing from a mere regularity only prompts surprise.

   Standards-based definitions are also unduly inclusive, because they encompass types of standards that are not characterized as norms in ordinary language. Norms are only one kind of standard. Another consists of explicit private rules, such as the rules of organized baseball. Although rules of this sort are regularly enforced and complied with, they are seldom if ever referred to as norms. A third kind of standard consists of cultural values, such as whether social standing is based on merit or lineage, whether there is social approval or disapproval of commerce and merchants, and whether the society's ideology emphasizes individuals or groups. Like explicit rules, cultural values are usually not called norms.

   In short, social standards range in a spectrum from explicit private rules, through norms, to cultural values. Two elements characterize movement along this spectrum. The first element is specificity. Usually, explicit private rules are highly specific; norms are less specific; and cultural values are highly general. The second element is the mechanism of creation and change. Explicit private rules are promulgated, amended, and repealed. Norms evolve as practices and commitments shift. Cultural values are transmitted through socialization into a way of life.

   Bearing all these considerations in mind, we define norms as social standards and regularities other than explicit private rules or cultural values.

   Like the general society, every firm has its own rules, norms, and cultural values, which we call firm-specific. Our particular interest in this Article is in firm-specific fairness norms, that is, norms of a firm that require fair conduct by its agents.

2. FIRM-SPECIFIC FAIRNESS NORMS AND EFFICIENCY

   People can often create value by cooperating with one another. The value that they create must be distributed. Disputes over distribution impede cooperation and waste resources. Fairness norms reduce disputes over distribution. Our first thesis is that firm-specific fairness norms promote a firm's efficiency by increasing cooperation among its agents. Next we explain several manifestations of the efficiency of firm-specific fairness norms.

   1. Loyalty

      To begin with, firms can be efficient only if their agents render loyal performance, by which we mean that the agents perform their contractual obligations diligently and honestly. Diligent and honest agents create value by cooperating with their firms and co-agents, whereas disloyal agents redistribute wealth to themselves by slacking and deceiving or otherwise betraying their firms and co-agents.

      One way to achieve loyal performance is by legal sanctions. Legal sanctions alone, however, have limited effectiveness, because detecting breaches of the duty of loyalty is difficult and legal enforcement is expensive.

      Bonding and monitoring provide other methods of achieving loyalty. For example, a corporation may award options to an agent that vest after a fixed number of years of employment. Such options bond the agent to the corporation in two ways. First, because the agent will do well if the corporation does well, the agent has an incentive to do what is best for the corporation. Second, if the corporation detects disloyalty by the agent during the relevant period, it can discharge the agent before the options vest, so that the agent loses the options. Additionally, a firm may employ external and internal auditing systems and various compliance programs to monitor its agents.

      Like legal sanctions, bonding and monitoring devices are expensive and have limited effectiveness. A more effective and reliable method for ensuring loyalty is the development of a regime of firm-specific fairness norms. As we explain below, developing such a regime also has costs, but the costs are typically lower than those associated with either legal enforcement or bonding and monitoring. Legal sanctions, monitoring, and bonding all have an important place in ensuring diligence and honesty by agents, but norms have the central role in achieving that objective.

   2. Supracontractual Performance

      In Part II.A, we explained that firm-specific fairness norms promote efficiency by inducing diligent and honest performance of contractual obligations. However, firms will be most efficient if agents go beyond their contractual obligations. For example, subordinates may put in longer hours and exert more effort than their contract requires, in which case we say that performance is supracontractual. Firms have an obvious efficiency interest in inducing supracontractual performance.

      A subordinate who performs supracontractually will normally do so because she forms a reasonable, noncontractual expectation that, when the time comes, her superiors will reward her with a raise or a promotion or in some other way. Such expectations are special cases of the well-known phenomenon of implicit contracts. In such cases, however, it is often easy and profitable (at least in the short run) for superiors to exploit the subordinates' trust by not fulfilling the latters' expectations. Accordingly, before agents render supracontractual performance they need a reasonable degree of assurance that their trust will not be exploited opportunistically.

      In a world of perfect information and no transaction costs, agents could protect against this kind of opportunism by contract. A perfect contract would encompass the subordinate's future performance, endogenous changes in the firm, exogenous changes that affect the firm, and what constitutes fair treatment under a variety of circumstances. In the real world, contractual protection of this sort usually fails because the needed terms are difficult to specify, observe, and prove.

      Firm-specific fairness norms enter to supplement imperfect contracting.(3) Two kinds of firm-specific fairness norms are relevant. The first consists of firm-specific versions of general fairness norms, such as "Reciprocate within the firm," and "Don't lie within the firm." These norms are firm-specific rather than general, because at least in principle they are compatible with norms that tolerate acting nonreciprocally and telling lies to people outside the firm. The second kind of firm-specific fairness norm consists of norms that help define fairness within the firm. For example, compensation depends on seniority in some law firms, while in others it depends on the amount of business that a partner generates. Paying a young partner top compensation could be fair in the second context and unfair in the first.

   3. Mentoring

      Continuity in most firms requires a mentoring system under which superiors train...