Essay: Of Markets, Morals and Men

"Of Markets, Morals and Men" is an essay I wrote for The Association of Private Enterprise Education (APEE) 2006 essay contest. The essay received 5th place, an honorable mention.



Of Markets, Morals and Men



While markets don’t turn men into angels, they do provide incentives to curb unethical behavior. In fact, the more closely an existing market approaches its theoretical model, the more ethically its participants will act. Yet newspapers sensationalize corporate fraud and underreport statistics that would provide a more balanced perspective. Giving way to fear over facts, public opinion pushes for government market regulation and business ethics standards. Neither of these policies, however, achieves its desired outcome. Governments, public opinion and markets would all benefit if they were to realize what this essay will show: markets are good for morality.

Categorizing behavior along ethical standards complicates every discussion of business ethics. Under commonplace definitions of “ethical” — “morally right, honorable, virtuous, decent”i behavior — theft, perjury and fraud are obviously unethical. Other practices escape easy categorization. Is a ban on insider trading — a transaction based on information not available to the public — an example of bad laws (because law prohibits a performance incentive for managers) or of bad morals (because law prohibits it)?ii The Qur’an, like Medieval Catholicism, prohibits its adherents from charging interest. Should our conception of ethics include this definition as well? Because such puzzles are the purview of entire essays,iii this one will assume some commonly-accepted definitions of ethics: no fraud, no theft, no lies.

Now that we understand ethics, let’s understand markets. A free market, broadly defined, is an arena (such as a bazaar, the New York Stock Exchange, or eBay) where people meet to exchange goods or services (such as apples for oranges, stock options for money, or money for bread). Differences in people’s possessions and abilities, combined with differences in their wants and needs, create opportunities for mutually-beneficial trade. As people interact in a free market, self-interest encourages them to maximize the satisfaction of their demands and discourages them from paying the full cost of that satisfaction. Critics claim that this contradiction between the desires to maximize benefit and minimize cost motivates unethical behavior. They overlook, however, two important market mechanisms: repeat interaction and demand for information.

To understand repeat interactions, consider any restaurant.iv A cursory observer may think that customers have an incentive to under-tip (or not tip) the waiters, and waiters have an incentive to shirk, not bothering to re-fill glasses or wash the silverware. If the customer and the waiter both seek to maximize benefit and minimize cost, then the customer would rather pay less for his food, and the waiter would rather work less for the same tip. If the customer-waiter interaction is a one-time deal, then this behavior might hold true. Most interactions, however, are not one-time deals. Introduce repeat interactions and everything changes.

Imagine a customer who frequents a particular restaurant. He orders, eats, tips, and leaves—but plans to return. Now the customer, on the one hand, has an incentive to tip for service, lest the waiter remember him and refuse to serve him the next time — or worse, spit in his food! The waiter, on the other hand, has an incentive to serve well, lest the customer decide to switch waiters — or worse, switch restaurants! In the language of economic theory, repeat interactions increase the long-run cost to unethical behavior. For a rationally profit-maximizing actor, long-term cost outweighs short-term gain (irrational customers will be refused service, and for good reason!). Such is the power of repeat interactions that both actors behave ethically if they expect to meet again in the future.

The availability of accurate information similarly shapes behavior. Take Subway. The same atmosphere and menu throughout its global franchises says one thing: expect similar service in all Subway outlets. Subway knows that if one of its employees shortchanges Joe in Atlanta, Joe will tell his Atlanta friends to avoid Subway restaurants, and when he visits his cousins in Pittsburgh, his will tell them that, too. With such a spread of information, one person’s unethical act will produce first reputational, and then monetary, costs to the restaurant chain. So Subway’s network franchise has a monetary incentive to enforce ethical behavior, because for every Joe it disappoints, it stands the chance of losing the business of Joe’s friends and family. Such is the power of information.

In short, repeat interactions generate rules and guidelines for ethical behavior, while the access to information ensures actors don’t cheat those rules and guidelines. Not every market, unfortunately, offers perfect information and repeat interactions. This is because market efficiency is not a binary condition, but rather a matter of degree. Some markets are more efficient than others. On the one end of the efficiency spectrum, the New York Stock Exchange allows its participants to interact frequently using comprehensive and immediately available information. The stock prices Bloomberg displays are thus as accurate as can be, because Bloomberg’s reputation relies on it. On the other end of the spectrum, a tourist visiting a car mechanic on a secluded Arizona highway should be wary of getting cheated out of his money — not because people are less moral in Arizona, but because he is engaging in a one-time interaction with a mechanic about whom no information is available.v

Markets, therefore, enforce ethics. Where markets function efficiently, we can expect to find a high degree of ethical behavior. For markets to function efficiently, information needs to flow among suppliers, among consumers, and between suppliers and consumers; and all of them must interact frequently. It is true, however, that some markets are less efficient than others. By examining the evolution of one less-efficient market, we can gain insight into ethical behavior.

Let’s examine an unlikely candidate for ethical behavior: the political market.vi A democratic government can be described as a market for power. Candidates for political office supply good governance to citizens who demand different candidates by casting votes. Here the actors enter the market not to acquire a good, such as a car or a toaster, but to secure a future service. This gives the political market a special characteristic — one side of the transaction (the vote) occurs immediately, whereas the other side (governance) occurs over time. This market condition provides an incentive for elected candidates to underperform — that is, to provide a service less adequate than that expected by the electorate.

This observation is entirely correct. In fact, it was made in the 18th century by the father of utilitarianism, James Mill. Mill theorized that representative governments provide “the greatest happiness for the greatest number.”vii His only concern was that representatives might act to increase their happiness at the expense of the happiness of their electors. His solution was simple: frequent elections check arbitrary rule.viii In market terms, frequent elections are nothing more than repeat interaction between two exchanging parties, the voter and the representative. Unbeknownst to him, Mill was taking an inefficient free market, the 19th century parliamentary system, and trying to make it more efficient in order to increase ethical behavior. This essay can do little more than rephrase his analysis: better markets make better people.
If the more efficient a market, the more ethical its participants, then why the hype about unethical business? Two major sources have contributed to the increase in attention paid to business ethics over the past 20 years: the media and government regulation. Sensationalist newspapers and overeager pundits over-report the unethical behavior of individual firms — such as the recent fraud at Enron, WorldCom, Peregrine, and Tyco — and fail to put these cases in perspective by reporting statistical data on ethical breaches. As Dartmouth Trustee T. J. Rodgers tells us, while only “10 to 20 public corporations have been justifiably accused of serious wrongdoing,” that is only “0.1 percent of America's 17,500 public companies.”ix In comparison to the less-well functioning political market, that number is 10 times lower than the “failure rate” of U.S. presidents (defined as “forced or almost forced from office”).x

Unethical behavior also increases when governments, seeking to regulate markets, skew incentives. To measure whether bad behavior results from government regulation or “the inherent immorality of capitalism,”xi we must do the seemingly impossible: find markets free from government regulation. I have found two such markets: in Norway and, surprisingly, in Russia. Both examples show how markets without government intervention efficiently enforce ethical behavior.

The Oslo Mercantile Association (OME) in Norway provides a perfect example of a market-created enforcement mechanism that works. The OME was established in 1878 by Norwegian businessmen to defend general standards of business practice and adjudicate disputes among market participants.xii OME’s carefully kept records show that the standards set by the businessmen were, in fact, stricter than those defined by modern governments. For example, most of the complaints filed were for “disloyal conduct,” which OME described as “derogatory remarks concerning other tradesmen and their products” — a practice common in modern business. Over the course of OME’s existence (1880-1953, except during the Nazi occupation), the most egregious ethical violations, such as claims of “dishonesty,” “breach of confidence,” “failure to perform,” and “unreasonable demands,” all fell over time.xiii Claims of “disloyal conduct,” however, rose. This indicates that, as the market enforced compliance, ethical offenders moderated their misbehavior from the egregious to the inconsequential.

The Russian Commodity Exchange (RCE) provides a more recent example of government-free market ethics. Set up after 1989, the RCE inaugurated capitalism’s entrance into the former communist stronghold. Gorbachev’s government had just emerged from central planning, and had little experience with markets. “A centrally planned system,” Peter Hill tells us, “holds individuals much less accountable [than a market].”xiv The Russian Duma, therefore, put up no regulations to prevent closed-door dealings or to force participants to honor contracts. Unregulated and inexperienced, the RCE seemed set up to fail. So how did it fare? According to Kolosov, et al.,xv the RCE set up institutional rules to promote ethical behavior. The RCE followed no set laws and meted out no set punishments; rather, it evaluated each offense on a case-by-case basis, and then simply announced its finding for or against the accused. The brokers themselves punished the convicted by refusing to trade with them. Punishments also ranged from temporary suspensions to permanent losses of business, in accordance with the severity of the offenses. Unsurprisingly, Kolosov, et al., point out two mechanisms that facilitated such regulation: repeat interaction and access to information.xvi Thus, with neither government regulation nor market experience, the Russian Commodity Exchange promoted ethical behavior in its effort to increase market efficiency.

So markets can efficiently enforce ethics, but maybe governments can do a better job? We cannot tell, because government regulation, just like market efficiency, is a matter of degree. Economists do know, however, that more government regulation always makes a market less efficient in terms of profit. Increased regulation requires increased paperwork, increased oversight, and decreased maneuverability for market participants. Regulation raises transaction costs, and high costs deter business. Both efficiency and regulation are a matter of degree, but whereas more market efficiency certainly means better ethics, more government regulation means less efficiency, and maybe better ethics. While the jury is still out, governments should avoid enforcing ethics, lest they fail at both ethics and efficiency.

Unethical behavior exists inside and outside of markets. Unfortunately, when men act unethically outside of markets, we blame them, but when they act unethically as they sell, trade, or barter, we blame the market. As a system of determining prices and facilitating exchange, a market has no moral obligation. Market participants, however, soon realize that in order for markets to benefit them, they must act in a certain, ethical way. This is the market’s contribution to morality: Markets might not make angels out of men, but they can curb the worse demons of our nature.


Works Cited

Friedman, Milton, John Mackey, T.J. Rogers. “Rethinking the Social Responsibility of Business.” Reason. Oct., 2005. Accessed Nov. 13, 2006. .

Hill, Peter J. “Markets and Morality.” Bozeman, MT: Political Economy Research Center. 1988.

Kolosov, Michael, et al. “Ethics and behavior on the Russian commodity exchange.” Journal of Business Ethics. Vol. 12. 1993. pp. 741-744.

Lewis, Phillip V. “Defining ‘business ethics’: Like nailing jello to a wall.” Journal of Business Ethics (1985).

Lunde, Johs. “Business Ethics in Norway.” The Business History Review. Vol. 33. No. 3. Autumn, 1959. pp. 401-408.

McMurtry, John. Value Wars: The Global Market Versus the Life Economy. Pluto Press, 2002.

Mill, James. “On Government,” in Jack Lively & John Rees, Utilitarian Logic and Politics. Oxford: Oxford University Press, 1984. pp. 72-28.

Moore, Jennifer. “What is really unethical about insider trading?” Journal of Business Ethics (1990). pp. 171-182.

NBC4. “Is your mechanic cheating?” Accessed Nov. 4, 2006. .

Wilson, James Q. “The Free Society Requires a Moral Sense, Social Capital.” Interview. July/Aug., 1999. Religion and Liberty. Accessed Nov. 13, 2006. .

ENDNOTES

i “Ethical,” Oxford English Dictionary Online. Accessed Nov. 4, 2006.
ii For a discussion on the ethics of regulating insider trading, see Jennifer Moore, “What is really unethical about insider trading?” Journal of Business Ethics (1990) pp. 171-182.
iii For a discussion of the definition of business ethics, see Phillip V. Lewis, “Defining ‘business ethics’: Like nailing jello to a wall,” Journal of Business Ethics (1985).
iv This example flows from James Q. Wilson’s description of restaurants and markets in James Q. Wilson, “The Free Society Requires a Moral Sense, Social Capital,” Religion and Liberty, Interview, July/Aug., 1999.
v A national mechanic service like Jiffy Lube, however, self-enforces anti-fraudulent behavior as soon as information of its misconduct becomes available to the public. (NBC4, “Is your mechanic cheating?” Accessed Nov. 4, 2006, .)
vi Peter Hill makes private property central to his definition of markets. If each citizen controls his or her vote, then that vote can be considered a form of private property. (Peter J. Hill, “Markets and Morality” (Bozeman, MT: Political Economy Research Center, 1988), p. 1.)
vii James Mill, “On Government,” in Jack Lively & John Rees, Utilitarian Logic and Politics (Oxford: Oxford University Press, 1984), pp. 72-28.
viii Mill, in fact, called for annual elections, which is much more frequent than modern parliamentary elections, which must occur at least every five years.
ix “Rethinking the Social Responsibility of Business,” by Milton Friedman, John Mackey, and T.J. Rogers, Reason, 2005, Oct., .
x Ibid.
xi John McMurtry, Value Wars: The Global Market Versus the Life Economy (Pluto Press, 2002), Introduction.
xii The brief summary of the OME comes from Johs Lunde, “Business Ethics in Norway,” The Business History Review, Vol. 33, No. 3 (Autumn, 1959), pp. 401-408.
xiii In the language of modern economic theory, these violations would be called, respectively, misinformation, default and unfair contracts.
xiv Peter J. Hill, “Markets and Morality” (Bozeman, MT: Political Economy Research Center, 1988), p. 3.
xv Michael A. Kolosov, Deryl W. Martin and Jeffrey H. Peterson, “Ethics and behavior on the Russian commodity exchange,” Journal of Business Ethics, Vol. 12, 1993, pp. 741-744.
xvi About repeat interaction, Kolosov, et al, said: “Seldom is a market participant seeking a one-time transaction.” About information, they said: “To be trusted for larger transactions involving deferred delivery, and larger profits, the unethical broker must earn back his respectability over time.”