Morality, Competition, and the Firm: The Market Failures Approach to Business Ethics.

AuthorRauterberg, Gabriel V.
PositionBook review

Morality, Competition, and the Firm: The Market Failures Approach to Business Ethics. By Joseph Heath. New York: Oxford University Press. 2014. Pp. ix, 372. $65.

The social responsibility of business is to increase its profits.

--Milton Friedman (1)

Economic justice is concerned with the fairness with which benefits and burdens ... are distributed ... among organizational stakeholders.

--Newman S. Peery, Jr. (2)

The vast majority of economic activity is now organized through corporations. The public corporation is usurping the state's role as the most important institution of wealthy capitalist societies. Across the developed world, there is increasing convergence on the shareholder-owned corporation as the primary vehicle for creating wealth. (3) Yet nothing like this degree of convergence has occurred in answering the fundamental questions of corporate capitalism: What role do corporations serve? What is the goal of corporate law? What should corporate managers do? Discussion of these questions is as old as the institutions involved.

Contemporary reflection on these questions takes the form of two starkly different and estranged orthodoxies. (4) Both are now decades old, but neither shows any sign of either subsiding or emerging victorious. In corporate finance, economics, and most of corporate law, the orthodoxy is that a corporation should aim exclusively to maximize shareholder value within the constraints established by law ("shareholder theory"). (5) In business ethics, the leading view is that corporate managers should balance the interests of all the constituencies affected by a firm's actions, including employees, suppliers, consumers, owners, and the broader society ("stakeholder theory"). (6)

Joseph Heath's new book, Morality, Competition, and the Firm, (7) revisits these questions. Heath criticizes the two standard views and develops an alternative, which he calls a "market failures" approach (p. 1). Heath endorses much of the shareholder view, but offers a powerful critique of its application. In essence, he suggests that it is managers' ethical responsibility to pursue shareholder wealth maximization if, and only if, doing so is conducive to aggregate social efficiency. (8) Often this will be the case, but under conditions of market failure--when the allocation of goods and services in a market is inefficient for some reason--it is possible to increase shareholder wealth without contributing to social efficiency. Heath's approach forbids corporate managers from pursuing shareholders' interests when doing so exploits a market failure. This simple ideal of corporate managers as custodians of social efficiency turns out to have dramatic implications for business ethics.

The scholarship addressing what corporate managers should aim to achieve is extensive. (9) What sets Heath's book apart is the remarkable breadth of legal, economic, and political analyses that he brings to bear and the brilliance with which he synthesizes them. (10) This book is one of the new century's most important contributions to addressing capitalism's fundamental questions.

This Review begins with the foundations of the market failures approach and a critique of the shareholder and stakeholder views. Heath's critical project is largely successful and surely one of the most important contributions of the book. I then turn to the viability of the market failures approach. While sympathetic to the insights driving it, I ultimately find the market failures view to be far more exacting than Heath imagines it to be. Heath's book aspires to offer both compelling and realistic ethics for corporate managers, and it is in his second aspiration that I think he fails. This is, in itself, rather striking. Heath explicitly takes his vision of corporate purpose and managerial ethics to consist solely of the pursuit of efficiency, which he calls a kind of "implicit morality of the market." (11) Yet even the naked goal of social efficiency imposes a set of moral requirements so demanding as to be plainly utopian.

I then turn to what I take to be a clear-eyed--some might say pessimistic--assessment of the prospects for any demanding business ethic within the specific institutional environment of today's corporate marketplace. Specifically, I argue that features of that marketplace effectively punish any form of ethical conduct that cuts into corporate profits. In the current configuration, business ethics with bite is thus in a very real sense unsustainable. I suggest how we might imagine alternative environments in which corporations can aspire to more than profit.

  1. WHAT ARE CORPORATIONS FOR?

    There is nothing intrinsically valuable about the interests of shareholders. So how did a single-minded emphasis on pursuing their interests become the dominant view of corporate purpose across economics, corporate law, and finance? Few slogans have put down as deep roots in the academic, popular, and political imaginations as Milton Friedman's famous declaration that "The Social Responsibility of Business Is to Increase Its Profits." (12) Seeing the appeal of this view is thus important. Surprisingly, the easiest way to do so is through sketching the case for Heath's own approach.

    The basic architecture of the market failures approach is to focus on the normative goal of a system of private, market-based competition among producers and consumers, and then to elaborate a set of ethical principles based on promoting that goal. The goal is a simple one--social efficiency. The simplest way to see this is that the law actually prohibits forms of cooperation that are promoted by everyday morality, effectively demanding that firms compete with one another. In particular, antitrust laws generally prohibit agreements among businesses in the same area to stop competing with each other. (13) Corporate managers who agree, for instance, to charge the same price--and thus to "defect" from market competition--can go to prison as a result. (14) This is despite the fact--or rather because of it--that price competition is a kind of prisoner's dilemma for the firms involved, in which the outcome is suboptimal for all of them, but conducive to economic efficiency at a social level. (15)

    Thus, the highly competitive markets that are characteristic of developed economies do not simply appear by happenstance. They arise within a well-structured legal environment, which clearly defines and enforces contract and property rights (16)--and as mentioned, firms compete within a legal environment that expressly prohibits cartelization. (17) A well-functioning market is thus a kind of staged competition or institutionalized collective-action problem designed to achieve the benefits of specific forms of competition and avoid the pathologies associated with monopolies or price-fixing (pp. 5, 33).

    The reason for seeking competitive markets is explained on the first day of Economics 101. A competitive market leads to an efficient allocation of resources. (18) Goods and services are directed toward those who express the greatest willingness to pay for them, and informative prices arise from the equalization of supply and demand. (19) Heath thus takes efficiency to be the ultimate justification for market-based capitalism and the appropriate goal of corporate managers (p. 10). Markets are "essentially special-purpose institutions designed to promote efficiency" (p. 10).

    It would be more accurate to call the "market failures" approach to business ethics an "efficiency" account, as its guiding idea is that the ethic of business managers is to operate corporations to promote social efficiency. It bears emphasizing that this does not mean corporate managers are supposed to have social efficiency in mind whenever they make business decisions. In any adversarial context, participants can generate social benefits by competing against each other--benefits that they need not personally have in mind (p. 28). For example, lawyers contribute to the justice of the adversarial system by zealously pursuing their clients' cases, and athletes contribute to great athletic spectacles by pursuing their own victories. (20)

    Indeed, managers' usual contribution to competitive markets is competing well, which means maximizing the value of the firm's net product. This is equivalent to maximizing the value of the residual claim, that is, the return to owners. Because most firms are owned by equity shareholders, maximization of the residual claim means maximizing profits (profit is the revenue of a firm leftover after all of a firm's contractual obligations have been satisfied). (21) Thus, the typical way in which managers promote social efficiency is by pursuing shareholder wealth maximization. Heath thus walks us through the basic insights that lead quite naturally to the shareholder wealth maximization view of corporate ethics. That view boils down to the thesis that markets in which profit-seeking firms compete against each other generate benefits for all of society, and that the way to best ensure that firms are maximally profit-seeking are for managers to maximize the profits of a firm's owners (pp. 28-33).

    1. The Market Failures Approach

      So how does the market failures approach differ from the shareholder view? The key idea of the market failures approach is that, while pursuing shareholder wealth maximization will promote social efficiency under many circumstances, there are a wide variety of situations in which this is not the case. Under those circumstances, corporate managers are obliged to not maximize shareholder value because doing so does not promote social efficiency.

      There are two important and distinct claims here. The first is identifying the conditions under which pursuit of firm profitability does not promote economic efficiency. These conditions are referred to as market failures. (22) For market competition to generate Pareto efficiency, a number of restrictive conditions...

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