European Journal of Law and Economics, 11:2; 153]164, 2001Q 2001 Kluwer Academic Publishers. Manufactured in The Netherlands.

Business Ethics as Corporate Governance1

STEEN THOMSEN st.marktg@cbs.dkCopenhagen Business School, Solbjerg Plads 3, 2000 Frederiksberg, Denmark

Abstract

The paper analyses ethical business codes as governance mechanisms, i.e. institutions which facilitatecoordination of economic behaviour. Ethical business codes are compared to other social institutionsŽ .market solutions, government intervention, the prevailing social ethic , and their efficiency is evaluatedin terms of transaction costs. A normative rationale for ethical codes is found when other institutionsfail to achieve socially optimal outcomes, in particular when the firm has access to unique information.Some economic incentives are identified which induce firms to commit to socially optimal ethical codesbut it is argued that economic forces will not in general be sufficient for optimality.

Keywords: business ethics, corporate governance, institutional economics, market failure

JEL Classification: L21, G34, K40

1. Introduction

Contrary to common belief business ethics is not inconsistent with modern eco-Ž . Žnomic theory. Both opponents Friedman 1970 and advocates Reilly and Kyj

.1990 of corporate social responsibility have stressed the inconsistencies. ForŽ .example Reilly a Kyj 1990 argue that ‘‘Ethics and corporate social responsibility

cannot be integrated into business thought if the assumptions of economics areaccepted’’. In this paper it is argued that institutional economics contains arudimentary theory of ethical codes which is limited in scope and far from fullydeveloped but may nevertheless be helpful to companies in defining what issues anethical code should address and for policy-makers in forming realistic expectationsof what ethical codes may be expected to accomplish.

The paper defines an ethical business code as a set of principles which acompany adopts in order to influence the behaviour of its employees. It will beassumed throughout that these principles are implemented to some extent throughits internal incentive system. For example, if the firm is committed to be an equalopportunities employer, business unit managers who continuously violate the coderisk being passed over for promotion. Therefore it is assumed that ethical codeswill to some extent. be reflected in company behaviour. In this simplified view,ethical questions are mainly addressed by the company’s top decision makers

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Ž Ž ..owners and board s whereas the employees respond to the incentive systems thatimplement the code.

The paper deals with the role of ethical business codes in corporate governance,Ž .governance being defined in the broad sense used by Williamson 1996 and others

as the institutions by which the firm’s activities are coordinated. Governancediffers from management by being concerned only with setting up and monitoring

Ž .the rules of the game institutions whereas the implementation of the rules is leftto the management.

The central questions addressed are whether ethical codes can play a role in thecorporate governance of a business firm and to what extent this role may beexpected to benefit social welfare. It is argued that ethical business codes mayfunction as a correction to market and policy failures as well as failure of theprevailing social ethic to achieve socially optimal outcomes.

The paper relies very much on standard economic concepts that may seemcontroversial when applied to ethical analysis. For example, following a tradition ingame theory often applied to prisoners’ dilemma games, it will be argued that one

Ž .ethical code which induces cooperation can be said to be more ethical thanŽ .another which does not because it leads to socially optimal outcomes. If one takes

Ž .into account that there are costs of inducing ethical behaviour cooperation , itfollows that optimal ethical codes will also depend on such costs. For example, if

Žthe costs of issuing and sustaining ethical codes exceed the gains from coopera-. Ž .tion , then an apparently unethical outcome no cooperation may be ethical in an

deeper sense.Clearly, this approach bypasses a number of important problems and the range

of issues which can be analysed in this way are limited. It is not the intention of thepaper to give a cost benefit analysis of universal values or ethical systems2 but tofocus on the more marginal issue of whether it makes sense for a company to

Ž .include a specific issue in its formal or informal ethical code. Should an ethicalbusiness code support a particular political party?3 Should it include preferenceson which countries or technologies to invest in? Should a company refuse to investin the arms industry? In the tobacco industry? In companies which supply thetobacco industry with important inputs? It is certain that a line will have to bedrawn somewhere.4 This paper aims to demonstrate that institutional economicanalysis can contribute both to defining a normative role for ethical codes and toassessing their actual function.

2. Business ethics as a governance mechanism

Formally, both ethics and economics are concerned with the determination ofŽ .social values. But while the neoclassical theory of value Debreu 1959 is concerned

with values in the form of relative prices, ethics is normally concerned withŽ‘‘non-economic’’ values which are not expressed in relative prices, at least not

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.directly . For example, voluntary work is generally considered to be ethical whileŽwork for pay is generally considered to be value neutral neither ethical nor

.unethical . But institutional economics also examines non-market institutions.Important modern contributions to the economic theory of ethics include ArrowŽ . Ž . Ž . Ž .1962, 1969, 1973, 1974 , Sen 1993 , Binmore 1994 and Franks 1987 . A survey is

Ž .given by Hausman and McPherson 1993 .Much of this literature has been concerned with ethics in general, but this paper

will attempt to parcel out a specific role for business ethics when defined as a codeof ethics adopted by a particular company. Ethical business codes adopted byindividual corporations must therefore be distinguished from general ethical codesexpressed in the prevailing social ethic. And both actual business codes and theprevailing social ethic must in turn be distinguished from ideal ethical codes whichŽ . Ž .however difficult to define would lead to or at least be consistent with anŽ .unknown social optimum, i.e. an allocation of resources and set of activities whichis considered to be socially optimal with given social objectives. This optimumcould include conditions on the distribution of income, attention to the naturalenvironment etc., but must also according to standard economic reasoning be

Ž .economically feasible and non-wasteful Pareto optimal . In particular, optimalityrequires an optimal use of institutions which will be the main concern of thispaper.

Both ethical business codes and social ethics can be regarded as sets ofŽ .principles which govern influence the company’s behaviour. In institutional

economics an ethical code is therefore a governance mechanism which serves tocoordinate economic activities. The market or price mechanism is another institu-

Ž .tion. So is hierarchical coordination by way of authority which takes placebetween bosses and their subordinates in most organizations.

Different mechanisms governing the supply of blood provide an illustrativeŽexample of ethics as an economic institution Titmuss 1971, Arrow 1972, Institute

.of Economic Affairs 1973 . A supply of blood can be obtained from voluntaryŽ . Ž .donors as often in the UK , it can be bought on the market often in the US ,

Žsoldiers can be ordered to give blood, blood can even be taken from prisoners as is.known to be the case in some military dictatorships . In principle, an entrepreneur

could start a blood firm and employ people with particularly excellent blood vesselsŽto produce blood although this would probably be impractical for both medical

.and economic reasons . A formal or informal ethical code requiring all employeesŽin a company to give blood once a year or encouraging them to do so by formal or

.informal incentives can also be regarded as an institution.Given this simplifying assumption, a choice can be made between alternative

governance mechanisms in terms of their relative costs, usually termed ‘‘transac-tion costs’’. Obviously, transaction cost must enter into the definition of the socialoptimum. The lower the transaction cost incurred in attaining a given outcome, themore resources are freed for other purposes. Institutional economics predicts thatcost considerations will induce the agents in the economy to choose the least-cost

Ž .alternative which minimizes transaction costs .

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For example, a national health service responsible for blood supply is faced withŽa choice of social institutions i.e. to ‘‘leave it to the market’’, to the social ethic, or

.to use various types of government intervention . With a given budget the nationalhealth service might consider the cheapest possible way of attracting the necessarysupply of blood. Voluntary blood supply may be relatively cheap to administer, butit may be costly to persuade citizens to adopt ethical codes which induce them togive blood. Another possibility is to pass laws obligating citizens to give blood, but

Ž .this may impose large hidden costs on the country’s citizens. A third way is toŽleave it to ‘‘pure’’ market solutions private businesses or other organizations

.operating on a commercial or non-profit basis .Institutional economics predicts that non-market governance mechanisms will

arise under conditions of market failure: ‘‘ . . . when the market fails to achie e anoptimal state, society will, to some extent at least, recognize the gap and nonmarket

Ž .institutions will arise attempting to bridge it ’’ Arrow 1962 p. 21 . Market failurearguments can motivate government intervention in the markets, but also other

Ž .types non-market institutions Arrow 1961 p. 22 .Ž .As an illustration of this principle Arrow 1963 argued that a medical ethic

among doctors is a way to overcome failures in the market for medical services dueto information asymmetries between doctors and patients. Because patients gener-ally lack information about the nature of their illness and effectiveness of alterna-tive treatments, doctors could manipulate them in their own interest. A medicalethic among doctors enforced by powerful collective sanctions helps to overcome

Ž .this problem Arrow 1973 p. 139 . Arguably, this medical ethic would not have beennecessary had the prevailing social ethic been strong enough to prevent opportunis-

Ž .tic behaviour from occurring among all citizens doctors included . And to theextent that all doctors are motivated by a medical ethic it is not necessary forindividual hospitals to introduce their own ethical codes.

These considerations point to a degree of substitutability between different kindsof ethics and tend to support a division of labour between alternative kinds ofethical codes as well as between ethical codes and other institutional arrangements.The implication is that there will be a rationale for ethical codes when alternative

Žgovernance mechanisms pure markets, hierarchies, government, the prevailing.social ethic fail to achieve a social optimum. For example, an ethical business code

encouraging all employees to give blood once a year would increase social welfareto the extent that an adequate blood supply is neither produced by market forcesnor the political systems or voluntary action.

The conditions for market failure have been extensively explored in economics.The formal definition of market failure is that prices deviate from marginal socialcosts which is predicted by microeconomic theory to occur under conditions of

Žmonopoly and externalities combined with significant transaction costs e.g. the.information costs associated with writing and enforcing contracts .

The conditions for go¨ernment failure are also beginning to be appreciated. Ifmarket failures were automatically corrected by government intervention there

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would be no scope for alternative allocation mechanisms like ethical codes.Although the theory of government failures is less well developed, tentative

Žexplanations are provided in the public choice literature for a survey see Mitchel.and Simons 1994 . For example, powerful interest groups may influence the

political process to their advantage at the cost of the general public causing a netŽ .reduction in social welfare Olson 1965 .

In contrast, the conditions for social ethics failure have received almost noŽ .attention in institutional economics. Arrow 1961 mentions in passing that a

medical ethic can also have negative effects if it serves as a barrier to entry whichŽ .confers monopoly advantages on the medical profession. Elster 1988 give a series

of examples of privately and collectively inefficient social norms, for exampleinformal norms that limit the use of monetary transfers in some circumstances.

Ž .Theoretically, Douglas North 1990 has emphasized that powerful interest groupsmay have a vested interest in the status quo and may therefore support ethicalstandards which ‘‘lock in’’ the economy into stagnation. A classic sociological study

Ž . Ž .by Banfield 1958 found that extreme uncertainty high death rates and povertyamong Italian peasants created a family-centered ethic which blocked socialcooperation between members of different families.

It has been asserted that social values change only slowly and that this may putŽ .them at odds with optimality North 1990 p. 87 . Some theoretical support for this

may be found in the influential line of research in game theory that models ethicsŽ .cooperation as the outcome of a series of repeated games of the prisoners’

Ž .dilemma type Hausmann & McPherson 1993, Binmore 1994 . Conceivably it mayŽ .take many games a long time for customs and value systems to adopt to new

Ž .circumstances. If ethical codes emerge in an evolutionary game Friedman 1991the prevailing codes may be sub-optimal for extended periods of time which couldhave detrimental direct effects on welfare as well as spill over effects on policiesand markets.

Ž .Schumpeter 1934, 1938, 1950 suggested an inherent contradiction betweencapitalism and the prevailing social ethic. In a primitive ‘‘circular flow’’ economy

Ž .Schumpeter 1934 argued that economic activity is essentially stable except forŽ . Žstochastic influences e.g. the weather . Technology is fixed there is no technologi-

. Ž .cal process , there is no net saving or investment Schumpeter 1938 , and thestandard of living remains unchanged from year to year. In this static society

Ž .adherence to a finite set of unchanging codes rituals, customs, social norms is aviable way of coordinating economic activity. In technical economic terms one canimagine that producers and consumers have already adjusted their plans to a set ofequilibrium prices. Once these adjustments have been made, all that remains for

Ž .producers and consumers to do is to implement their contingent plans, which in astationary equilibrium is ‘‘business as usual’’. According to Schumpeter the role ofthe entrepreneur and the business firm in this system is to disturb this circular flowthrough a process of creative destruction: setting up new types of production andout-competing existing producers. This is bound to lead to social upheaval and to

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challenge existing ethical codes. The entrepreneur will therefore most likely seemunethical judged by the standards of the existing society.

A social ethic can be unethical if it blocks economic and social progress.Obviously this does not mean that ethics in general is unethical. Both SchumpeterŽ . Ž .1950 and Weber 1966 argued that capitalism itself is founded on a set of ethical

Ž .principles rationalism, hard work, saving . But neither can it be assumed that theprevailing social ethic will always work to correct failures in other governancemechanisms, nor that the prevailing social ethic will be optimal under all circum-stances.

In conclusion, failures in the prevailing social ethic combined with other gover-nance failures leave a potentially important social function for business ethicswhich appears to be neglected in the business ethics literature. The next sectionattempts to develop this viewpoint.

3. Optimal ethical codes

Ž .Arrow 1973 explicitly considered the scope for ethical codes of behaviour inmodifying the profit maximization objective of business companies. As already

Ž .indicated market failures may result from profit maximization with unpaid forŽ .external effects e.g. pollution and congestion . In addition, Arrow emphasizes the

information asymmetries which occur when a firm knows more about its productsthan the buyer}a parallel to the information asymmetry between doctor andpatient. In such cases, for example with regard to product safety, Arrow argues thatethical codes may be desirable because they can increase social welfare, especiallyif supported by government agencies, trade associations, consumer groups, andindividuals within the firm. Assuming that problems of a general and recurrentnature are handled by government intervention or by the general social ethic,ethical business codes should mainly be concerned with firm specific issues whichthe firm is in a unique position to solve.

This conjecture can be applied to environmental management by noting thatpollution problems can in principle be solved by market mechanisms when markets

Žare complete and there exist a complete set of property rights which according to.the Coase theorem will be the case when transaction costs are insignificant . An

Žimplication of this theory is that local pollution problems e.g. a factory polluting.the soil of a neighbouring farm may be solved by bargaining or court ordering. But

if the factory pollutes a lake with external effects on many people, the transactioncosts involved in private bargaining may make private ordering unviable. In thiscase there is scope for alternative solutions among which government regulation bytaxation of pollution according to the marginal social costs is often considered tobe appropriate to restore optimality. However, in case the government fails to

Ž .intervene for some reason information problems, lobbying by pressure groups , the

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externality problem remains unsolved and the firm can increase overall socialwelfare by adhering to an ethical code which takes the costs of pollution into

Ž .account for example by preventing or cleaning up pollution .The emphasis on firm specific issues is consistent with the so-called resource-

based view of the firm which sees firm specific resources as the fundamentalŽ .rationale for the existence of firms Wernerfelt 1984 . A prime example of such

assets is firm specific information such as firm specific knowledge which allows thefirm to produce better or cheaper products than its competitors. Firm specificinformation can create economic profits and give the firm a certain freedom ofaction which is absent in perfectly competitive markets that presumably force firms

Ž .to apply a common set of market-determined standards Baumol 1991 . This view isconsistent with the Schumpeterian view of the entrepreneurial firm as the bearerof an idea, a piece of new information, which is only gradually diffused. As long asthis information is unique to the firm policy makers cannot be expected to use it as

Ž .a basis for efficient welfare improving intervention. Furthermore the new ideasare likely to meet resistance from an establishment whose value system and ethical

Ž .standards reflect a vested interest in the status quo North 1990 .One way to incorporate this into ethical management is for the individual firm to

distinguish between general social ethical codes to which it must adhere and firmspecific codes in areas on which it has superior information. The general codes

Žshould reflect the firm’s perception of universal values in business e.g. the workethic, honesty and rationality believed by Weber to be the ethical foundations of

.capitalism . In contrast, firm specific codes may sometimes differ from the ethicalviews held by the rest of society. A biotechnology firm experimenting with technol-ogy and products which are unchartered territory for the general public carriesboth a special responsibility for safety and product standards and an obligation to

Ž .overcome social resistance including ethical criticism from the establishment. In achange resistant environment the social interest may be served by the nurture ofethical codes which differ from the prevailing social ethic.

In conclusion, there is a clear rationale for ethical codes in institutional eco-nomics. But this is not to say that the theory is fully developed. Among other things

Ž .it is open to the criticism of ‘‘Nirvana economics’’ raised by Harold Demsetz 1969in the context of analysing government intervention. The market economy is

Ž .compared to a theoretical ideal a state of Nirvana and if the real world does notŽ .live up to the ideal, ethical business codes are somehow like a Deus ex machina

supposed to restore optimality. Clearly, some refinement is warranted.

4. Profit maximization and ethical codes

This section aims to give more content to the functional argument for ethicalbusiness codes by examining the mechanisms which induce firms to adopt ethical

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Žcodes and to what extent they can be expected to adopt optimal welfare improv-.ing codes.

One way to go about this is to consider to what extent ethical codes areconsistent with profit maximization, the standard assumption on firm behaviour ineconomics. Defining ethical codes as a set of rules which limit the range ofacceptable activities, they might be considered to be inconsistent with profitmaximization, since a profit maximizing firm will have the same opportunities forprofit as an ethically constrained one plus the additional opportunities which mayarise from the option to be unethical. Technically, the decision to commit to anethical code can be understood as an irreversible investment decision underuncertainty in which the firm chooses to forsake certain future options, and the

Žcost can in principle be measured by real asset option theory Dixit and Pindyck.1994 . Giving up flexibility by committing to ethical codes is equivalent to giving

away put options, the opportunity costs of which are in principle given by the theirmarket value which will increase with level of uncertainty facing the business. For aprofit maximizing company to incur these costs there must be offsetting benefitsŽ .i.e. benefits as well as costs of commitment .

In game theory the benefits of commitment}‘‘the value of tying one’sŽ .hands’’}have been analysed extensively for example by Schelling 1960 . Arrow’s

analysis of medical ethics is an example. Other examples are not hard to come by.For example a manufacturer of computers can commit itself to providing aftersales service free of charge and to hold on to this principle even in the event thatproduction of computers will prove unprofitable and be shut down at a later date.It may be profitable ex ante to make this commitment binding because this willpersuade more customers to buy the computer in the first place and thereby reducethe ex ante probability that production will be unprofitable and have to be shutdown. An ethical code can have the same function and may thereby increase bothprofits and social welfare, but to make the scheme work it is necessary that thefirm ‘‘burns its bridges’’ and commits to ethical behaviour even in the event thatthis should prove to be ex post sub-optimal from the company’s viewpoint.5

Ethical behaviour may also be optimal from a selfish viewpoint in a sequence ofŽ .repeated games Schotter 1981, Binmore 1994 in which the stakeholders of a firm

get to know each other over time, and where selfish behaviour may be optimal inthe short run, but will be punished in subsequent games, and is therefore discour-aged. Concern for product safety because of possible damage to the company’sreputation is an example. Another example is a strong corporate culture or a‘‘mission’’ which can motivate employees to make an effort beyond what is

Ž .immediately selfish Hausman and MacPherson 1993 . Studies by Chen, SawyersŽ . Ž .and Williams 1997 and Nwachukwu and Vitell 1977 confirm that corporate

Ž .cultures can support firm specific ethical codes. In the theory of clans Ouchi 1980common values are regarded as an optimal organizational form in unstableenvironments where there is uncertainty with regard to both means and objectives

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}for example in product development where there is uncertainty both as to theexpected results and as to the best way to structure the work effort. If sociallyoptimal ethical codes support strong corporate value systems, this may provide anadditional argument for their consistency with profit maximization.

Despite these economic incentives to adopt ethical business codes it seemsunreasonable to assume that economic forces will always lead to optimality. Thereare at least two reasons for this.

First, the external pressure to adopt ethical codes may be lacking in preciselythose situations in which the social rationale for such codes appears to bestrongest, namely in situations where the firm has access to unique information.Unique knowledge may be a monopoly advantage which the unregulated, uncen-sored profit maximizing firm has an obvious incentive to exploit with as fewconstraints a possible. In a monopoly situation standard market pressure cannot beexpected to weed out unethical firms. And because of the firm specificity of theinformation, customers or policy makers may not be able to detect unethicalbehaviour so that concerns about reputation in repeated games may not be aneffective deterrent.

Secondly, a profit maximizing firm may find it difficult to commit irreversibly toan ethical code. A standard objection to introducing non-profit objectives incompany decision making is that the markets for corporate control will eliminate

Ž .managers who do not pursue value maximization strategies e.g. Ehrhardt 1995 .Ž .Shleifer and Summers 1988 argue that the source of value gains from mergers

and acquisitions is breach of implicit contracts, mainly with employees. A companymay currently be committed to long term employment policies which encourage itsemployees to invest in firm specific human capital. But what is to prevent takeoversand renegotiation of these implicit contracts in bad times? And if the firm cannotcredibly commit itself, will not the employees recognize this and refuse to make thenecessary investments in human capital ex ante? Obviously, the value of ethicalcommitments which do not reflect the preferences of company’s owners is open todoubt. And if ownership is to function as a basis for long term ethical commitmenta certain degree of stability and accountability is necessary as well. It may not beimpossible, for instance, to ensure loyalty to standard ethical codes among in-vestors but the sustainability of this commitment is open to doubt if the sameinvestors do not commit to a minimum holding period. In contrast to the Anglo-American corporate governance model more long term ownership is found in

Ž .Japan or Germany e.g Charkham 1994 .There is no doubt, however, that it will be in the interest of the profit maximizing

firm to signal commitment to ethical values if the signalling costs are small and ifŽan ethical appearance is perceived to have a positive financial effect Harrington

.1989, Frank 1989 . An implication is that business managers will find it in theirinterest to mimic ethical behaviour to the extent that the public cannot distinguishbetween honesty and dishonesty. The plethora of ethical business codes withunclear empirical content provide circumstantial evidence of this.

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5. Discussion

This paper has analysed ethical codes as a corporate governance mechanism andthe analysis was found to have both normative and descriptive implications forethical management. It was found that ethical business codes are especially likelyto improve social well-being if they concentrate on issues which are specific to theindividual firm. It was also argued that optimal firm specific ethical codes mightwell differ from the prevailing social ethic. The paper finally pointed to someŽ .imperfect mechanisms which induce firms to adopt optimal ethical codes.

Although the paper has presented what is believed to be a new approach to theanalysis of business ethics, the analysis remains rudimentary in several respects.For example, it has been confined to the standard economic definition of social

Ž .optimality efficient use of resources, none-wastefulness . But it is clear thatbusiness ethics may also involve a redistribution of resources in favour of the weak.Furthermore, the economic analysis of ethics is still in its infancy. In particularprofit or utility maximization may need to yield to alternative behavioural assump-tions.

Notes

1. I am grateful to Nicolai Juul Foss for helpful comments. Obviously he cannot be held responsible forthe paper’s remaining shortcomings.

Ž .2. On the limitations of economic analysis applied to such profound questions see Radin 1996 andŽ .Arrow 1997 .

3. Most Western business codes explicitly rule out support for a political party}e.g. IBM BusinessConduct Guidelines 2000.

4. A Danish pension fund, PFA, has adopted a set of ethical guidelines which prohibit investment in thecompanies involved in the arms industry, child labour, human rights violations in the home country,

Ž .atomic power and environmental problems the Danish business newspaper Børsen 22 May 1997 .Wher the fund was criticised in the media for holding shares in Phillip Morris and other tobaccocompanies the company spokesman responded that the fund considered smoking a matter of

Ž .personal privacy the Danish newspaper Politiken 6 August 1997 .Ž .5. Cf. Tirole 1988 : ‘‘ An oft-quoted example is that of two armies wishing to occupy an island between their

countries and connected by a bridge to both. Each army prefers letting its opponents ha¨e the island tofighting. Army 1, which is somewhat knowledgeable in game theory, occupies the island and burns thebridge behind it. Army 2 then has no option other than to let army 1 ha¨e the island, because it knows thatarmy 1 has no choice other than to fight back if army 2 attacks. This is the paradox of commitment: Army1 does better by reducing its set of choices.’’

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