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Business Ethics as Corporate Governance

Article  in  European Journal of Law and Economics · February 2001

DOI: 10.1023/A:1008791702733 · Source: RePEc

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

Business Ethics as Corporate Governance 1

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

Abstract

The paper analyses ethical business codes as governance mechanisms, i.e. institutions which facilitate
coordination of economic behaviour. Ethical business codes are compared to other social institutions
Žmarket solutions, government intervention, the prevailing social ethic., and their efficiency is evaluated
in terms of transaction costs. A normative rationale for ethical codes is found when other institutions
fail 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 codes
but 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-
nomic theory. Both opponents ŽFriedman 1970. and advocates ŽReilly and Kyj
1990. of corporate social responsibility have stressed the inconsistencies. For
example Reilly a Kyj Ž1990. argue that ‘‘Ethics and corporate social responsibility
cannot be integrated into business thought if the assumptions of economics are
accepted’’. In this paper it is argued that institutional economics contains a
rudimentary theory of ethical codes which is limited in scope and far from fully
developed but may nevertheless be helpful to companies in defining what issues an
ethical code should address and for policy-makers in forming realistic expectations
of what ethical codes may be expected to accomplish.
The paper defines an ethical business code as a set of principles which a
company adopts in order to influence the behaviour of its employees. It will be
assumed throughout that these principles are implemented to some extent through
its internal incentive system. For example, if the firm is committed to be an equal
opportunities employer, business unit managers who continuously violate the code
risk being passed over for promotion. Therefore it is assumed that ethical codes
will to some extent. be reflected in company behaviour. In this simplified view,
ethical questions are mainly addressed by the company’s top decision makers
154 THOMSEN

Žowners and boardŽs.. whereas the employees respond to the incentive systems that
implement the code.
The paper deals with the role of ethical business codes in corporate governance,
governance being defined in the broad sense Žused by Williamson 1996 and others.
as the institutions by which the firm’s activities are coordinated. Governance
differs from management by being concerned only with setting up and monitoring
the rules of the game Žinstitutions . whereas the implementation of the rules is left
to the management.
The central questions addressed are whether ethical codes can play a role in the
corporate governance of a business firm and to what extent this role may be
expected to benefit social welfare. It is argued that ethical business codes may
function as a correction to market and policy failures as well as failure of the
prevailing social ethic to achieve socially optimal outcomes.
The paper relies very much on standard economic concepts that may seem
controversial when applied to ethical analysis. For example, following a tradition in
game theory often applied to prisoners’ dilemma games, it will be argued that one
ethical code Žwhich induces cooperation. can be said to be more ethical than
another Žwhich does not. because it leads to socially optimal outcomes. If one takes
into account that there are costs of inducing ethical behaviour Žcooperation., it
follows that optimal ethical codes will also depend on such costs. For example, if
the costs of issuing and sustaining ethical codes exceed the gains Žfrom coopera-
tion., then an apparently unethical outcome Žno 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 the
paper to give a cost benefit analysis of universal values or ethical systems 2 but to
focus on the more marginal issue of whether it makes sense for a company to
include a specific issue in its Žformal or informal. ethical code. Should an ethical
business code support a particular political party? 3 Should it include preferences
on which countries or technologies to invest in? Should a company refuse to invest
in the arms industry? In the tobacco industry? In companies which supply the
tobacco industry with important inputs? It is certain that a line will have to be
drawn somewhere.4 This paper aims to demonstrate that institutional economic
analysis can contribute both to defining a normative role for ethical codes and to
assessing their actual function.

2. Business ethics as a governance mechanism

Formally, both ethics and economics are concerned with the determination of
social values. But while the neoclassical theory of value ŽDebreu 1959. is concerned
with values in the form of relative prices, ethics is normally concerned with
‘‘non-economic’’ values Žwhich are not expressed in relative prices, at least not
BUSINESS ETHICS 155

directly.. For example, voluntary work is generally considered to be ethical while

work for pay is generally considered to be value neutral Žneither ethical nor
unethical .. But institutional economics also examines non-market institutions.
Important modern contributions to the economic theory of ethics include Arrow
Ž1962, 1969, 1973, 1974., Sen Ž1993., Binmore Ž1994. and Franks Ž1987.. A survey is
given by Hausman and McPherson Ž1993..
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 code
of ethics adopted by a particular company. Ethical business codes adopted by
individual corporations must therefore be distinguished from general ethical codes
expressed in the prevailing social ethic. And both actual business codes and the
prevailing social ethic must in turn be distinguished from ideal ethical codes which
Žhowever difficult to define. would lead to Žor at least be consistent with. an
Žunknown. social optimum, i.e. an allocation of resources and set of activities which
is considered to be socially optimal with given social objectives. This optimum
could include conditions on the distribution of income, attention to the natural
environment etc., but must also according to standard economic reasoning be
economically feasible and non-wasteful ŽPareto optimal.. In particular, optimality
requires an optimal use of institutions which will be the main concern of this
paper.
Both ethical business codes and social ethics can be regarded as sets of
principles which govern Žinfluence . the company’s behaviour. In institutional
economics an ethical code is therefore a governance mechanism which serves to
coordinate economic activities. The market or price mechanism is another institu-
tion. So is Žhierarchical . coordination by way of authority which takes place
between bosses and their subordinates in most organizations.
Different mechanisms governing the supply of blood provide an illustrative
example of ethics as an economic institution ŽTitmuss 1971, Arrow 1972, Institute
of Economic Affairs 1973.. A supply of blood can be obtained from voluntary
donors Žas often in the UK., it can be bought on the market Žoften in the US.,
soldiers can be ordered to give blood, blood can even be taken from prisoners Žas 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 vessels
to produce blood Žalthough this would probably be impractical for both medical
and economic reasons.. A formal or informal ethical code requiring all employees
in a company to give blood once a year or encouraging them to do so by Žformal 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 social
optimum. The lower the transaction cost incurred in attaining a given outcome, the
more resources are freed for other purposes. Institutional economics predicts that
cost considerations will induce the agents in the economy to choose the least-cost
alternative Žwhich minimizes transaction costs..
156 THOMSEN

For example, a national health service responsible for blood supply is faced with
a choice of social institutions Ži.e. to ‘‘leave it to the market’’, to the social ethic, or
to use various types of government intervention.. With a given budget the national
health service might consider the cheapest possible way of attracting the necessary
supply of blood. Voluntary blood supply may be relatively cheap to administer, but
it may be costly to persuade citizens to adopt ethical codes which induce them to
give blood. Another possibility is to pass laws obligating citizens to give blood, but
this may impose large Žhidden. costs on the country’s citizens. A third way is to
leave it to ‘‘pure’’ market solutions Žprivate 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 an
optimal state, society will, to some extent at least, recognize the gap and nonmarket
institutions will arise attempting to bridge it’’ ŽArrow 1962 p. 21.. Market failure
arguments can motivate government intervention in the markets, but also other
types non-market institutions ŽArrow 1961 p. 22..
As an illustration of this principle Arrow Ž1963. argued that a medical ethic
among doctors is a way to overcome failures in the market for medical services due
to 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 medical
ethic among doctors enforced by powerful collective sanctions helps to overcome
this problem ŽArrow 1973 p. 139.. Arguably, this medical ethic would not have been
necessary had the prevailing social ethic been strong enough to prevent opportunis-
tic behaviour from occurring among all citizens Ždoctors included.. And to the
extent that all doctors are motivated by a medical ethic it is not necessary for
individual hospitals to introduce their own ethical codes.
These considerations point to a degree of substitutability between different kinds
of ethics and tend to support a division of labour between alternative kinds of
ethical 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
governance mechanisms Žpure 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 welfare
to the extent that an adequate blood supply is neither produced by market forces
nor 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 social
costs which is predicted by microeconomic theory to occur under conditions of
monopoly and externalities combined with significant transaction costs Že.g. the
information costs associated with writing and enforcing contracts..
The conditions for go¨ ernment failure are also beginning to be appreciated. If
market failures were automatically corrected by government intervention there
BUSINESS ETHICS 157

would be no scope for alternative allocation mechanisms like ethical codes.

Although the theory of government failures is less well developed, tentative
explanations are provided in the public choice literature Žfor 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 net
reduction in social welfare ŽOlson 1965..
In contrast, the conditions for social ethics failure have received almost no
attention in institutional economics. Arrow Ž1961. mentions in passing that a
medical ethic can also have negative effects if it serves as a barrier to entry which
confers monopoly advantages on the medical profession. Elster Ž1988. give a series
of examples of privately and collectively inefficient social norms, for example
informal norms that limit the use of monetary transfers in some circumstances.
Theoretically, Douglas North Ž1990. has emphasized that powerful interest groups
may have a vested interest in the status quo and may therefore support ethical
standards which ‘‘lock in’’ the economy into stagnation. A classic sociological study
by Banfield Ž1958. found that extreme uncertainty Žhigh death rates. and poverty
among Italian peasants created a family-centered ethic which blocked social
cooperation between members of different families.
It has been asserted that social values change only slowly and that this may put
them at odds with optimality ŽNorth 1990 p. 87.. Some theoretical support for this
may be found in the influential line of research in game theory that models ethics
Žcooperation. as the outcome of a series of repeated games of the prisoners’
dilemma type ŽHausmann & McPherson 1993, Binmore 1994.. Conceivably it may
take many games Ža long time. for customs and value systems to adopt to new
circumstances. If ethical codes emerge in an evolutionary game ŽFriedman 1991.
the prevailing codes may be sub-optimal for extended periods of time which could
have detrimental direct effects on welfare as well as spill over effects on policies
and markets.
Schumpeter Ž1934, 1938, 1950. suggested an inherent contradiction between
capitalism and the prevailing social ethic. In a primitive ‘‘circular flow’’ economy
Schumpeter Ž1934. argued that economic activity is essentially stable except for
stochastic influences Že.g. the weather.. Technology is fixed Žthere is no technologi-
cal process., there is no net saving or investment ŽSchumpeter 1938., and the
standard of living remains unchanged from year to year. In this static society
adherence to a finite set of unchanging codes Žrituals, customs, social norms. is a
viable way of coordinating economic activity. In technical economic terms one can
imagine that producers and consumers have already adjusted their plans to a set of
equilibrium prices. Once these adjustments have been made, all that remains for
producers and consumers to do is to implement their Žcontingent. plans, which in a
stationary equilibrium is ‘‘business as usual’’. According to Schumpeter the role of
the entrepreneur and the business firm in this system is to disturb this circular flow
through a process of creative destruction: setting up new types of production and
out-competing existing producers. This is bound to lead to social upheaval and to
158 THOMSEN

challenge existing ethical codes. The entrepreneur will therefore most likely seem
unethical 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 Schumpeter
Ž1950. and Weber Ž1966. argued that capitalism itself is founded on a set of ethical
principles Žrationalism, hard work, saving.. But neither can it be assumed that the
prevailing social ethic will always work to correct failures in other governance
mechanisms, 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 ethics
which appears to be neglected in the business ethics literature. The next section
attempts to develop this viewpoint.

3. Optimal ethical codes

Arrow Ž1973. explicitly considered the scope for ethical codes of behaviour in
modifying the profit maximization objective of business companies. As already
indicated market failures may result from profit maximization with Žunpaid for.
external effects Že.g. pollution and congestion.. In addition, Arrow emphasizes the
information asymmetries which occur when a firm knows more about its products
than the buyerᎏa parallel to the information asymmetry between doctor and
patient. In such cases, for example with regard to product safety, Arrow argues that
ethical codes may be desirable because they can increase social welfare, especially
if supported by government agencies, trade associations, consumer groups, and
individuals within the firm. Assuming that problems of a general and recurrent
nature are handled by government intervention or by the general social ethic,
ethical business codes should mainly be concerned with firm specific issues which
the firm is in a unique position to solve.
This conjecture can be applied to environmental management by noting that
pollution problems can in principle be solved by market mechanisms when markets
are complete and there exist a complete set of property rights Žwhich according to
the Coase theorem will be the case when transaction costs are insignificant .. An
implication of this theory is that local pollution problems Že.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 transaction
costs involved in private bargaining may make private ordering unviable. In this
case there is scope for alternative solutions among which government regulation by
taxation of pollution according to the marginal social costs is often considered to
be appropriate to restore optimality. However, in case the government fails to
intervene for some reason Žinformation problems, lobbying by pressure groups., the
BUSINESS ETHICS 159

externality problem remains unsolved and the firm can increase overall social
welfare by adhering to an ethical code which takes the costs of pollution into
account Žfor 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 fundamental
rationale for the existence of firms ŽWernerfelt 1984.. A prime example of such
assets is firm specific information such as firm specific knowledge which allows the
firm to produce better or cheaper products than its competitors. Firm specific
information can create economic profits and give the firm a certain freedom of
action which is absent in perfectly competitive markets that presumably force firms
to apply a common set of market-determined standards ŽBaumol 1991.. This view is
consistent with the Schumpeterian view of the entrepreneurial firm as the bearer
of an idea, a piece of new information, which is only gradually diffused. As long as
this information is unique to the firm policy makers cannot be expected to use it as
a basis for efficient Žwelfare improving. intervention. Furthermore the new ideas
are likely to meet resistance from an establishment whose value system and ethical
standards reflect a vested interest in the status quo ŽNorth 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 firm
specific codes in areas on which it has superior information. The general codes
should reflect the firm’s perception of universal values in business Že.g. the work
ethic, honesty and rationality believed by Weber to be the ethical foundations of
capitalism.. In contrast, firm specific codes may sometimes differ from the ethical
views held by the rest of society. A biotechnology firm experimenting with technol-
ogy and products which are unchartered territory for the general public carries
both a special responsibility for safety and product standards and an obligation to
overcome social resistance Žincluding ethical criticism. from the establishment. In a
change resistant environment the social interest may be served by the nurture of
ethical 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
it is open to the criticism of ‘‘Nirvana economics’’ raised by Harold Demsetz Ž1969.
in the context of analysing government intervention. The market economy is
compared to a theoretical ideal Ža state of Nirvana. and if the real world does not
live up to the ideal, ethical business codes are somehow Žlike 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 ethical
business codes by examining the mechanisms which induce firms to adopt ethical
160 THOMSEN

codes and to what extent they can be expected to adopt optimal Žwelfare improv-
ing. codes.
One way to go about this is to consider to what extent ethical codes are
consistent with profit maximization, the standard assumption on firm behaviour in
economics. Defining ethical codes as a set of rules which limit the range of
acceptable activities, they might be considered to be inconsistent with profit
maximization, since a profit maximizing firm will have the same opportunities for
profit as an ethically constrained one plus the additional opportunities which may
arise from the option to be unethical. Technically, the decision to commit to an
ethical code can be understood as an irreversible investment decision under
uncertainty in which the firm chooses to forsake certain future options, and the
cost can in principle be measured by real asset option theory ŽDixit 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 their
market value which will increase with level of uncertainty facing the business. For a
profit maximizing company to incur these costs there must be offsetting benefits
Ži.e. benefits as well as costs of commitment..
In game theory the benefits of commitmentᎏ‘‘the value of tying one’s
hands’’ᎏhave been analysed extensively Žfor 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 after
sales service free of charge and to hold on to this principle even in the event that
production 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 will
persuade more customers to buy the computer in the first place and thereby reduce
the ex ante probability that production will be unprofitable and have to be shut
down. An ethical code can have the same function and may thereby increase both
profits and social welfare, but to make the scheme work it is necessary that the
firm ‘‘burns its bridges’’ and commits to ethical behaviour even in the event that
this 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 of
repeated games ŽSchotter 1981, Binmore 1994. in which the stakeholders of a firm
get to know each other over time, and where selfish behaviour may be optimal in
the 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’s
reputation is an example. Another example is a strong corporate culture or a
‘‘mission’’ which can motivate employees to make an effort beyond what is
immediately selfish ŽHausman and MacPherson 1993.. Studies by Chen, Sawyers
and Williams Ž1997. and Nwachukwu and Vitell Ž1977. confirm that corporate
cultures can support firm specific ethical codes. In the theory of clans ŽOuchi 1980.
common values are regarded as an optimal organizational form in unstable
environments where there is uncertainty with regard to both means and objectives
BUSINESS ETHICS 161

ᎏfor example in product development where there is uncertainty both as to the

expected results and as to the best way to structure the work effort. If socially
optimal ethical codes support strong corporate value systems, this may provide an
additional argument for their consistency with profit maximization.
Despite these economic incentives to adopt ethical business codes it seems
unreasonable to assume that economic forces will always lead to optimality. There
are at least two reasons for this.
First, the external pressure to adopt ethical codes may be lacking in precisely
those situations in which the social rationale for such codes appears to be
strongest, 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 few
constraints a possible. In a monopoly situation standard market pressure cannot be
expected to weed out unethical firms. And because of the firm specificity of the
information, customers or policy makers may not be able to detect unethical
behaviour so that concerns about reputation in repeated games may not be an
effective deterrent.
Secondly, a profit maximizing firm may find it difficult to commit irreversibly to
an ethical code. A standard objection to introducing non-profit objectives in
company decision making is that the markets for corporate control will eliminate
managers who do not pursue value maximization strategies Že.g. Ehrhardt 1995..
Shleifer and Summers Ž1988. argue that the source of value gains from mergers
and acquisitions is breach of implicit contracts, mainly with employees. A company
may currently be committed to long term employment policies which encourage its
employees to invest in firm specific human capital. But what is to prevent takeovers
and renegotiation of these implicit contracts in bad times? And if the firm cannot
credibly commit itself, will not the employees recognize this and refuse to make the
necessary investments in human capital ex ante? Obviously, the value of ethical
commitments which do not reflect the preferences of company’s owners is open to
doubt. And if ownership is to function as a basis for long term ethical commitment
a certain degree of stability and accountability is necessary as well. It may not be
impossible, for instance, to ensure loyalty to standard ethical codes among in-
vestors but the sustainability of this commitment is open to doubt if the same
investors do not commit to a minimum holding period. In contrast to the Anglo-
American corporate governance model more long term ownership is found in
Japan or Germany Že.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 if
an ethical appearance is perceived to have a positive financial effect ŽHarrington
1989, Frank 1989.. An implication is that business managers will find it in their
interest to mimic ethical behaviour to the extent that the public cannot distinguish
between honesty and dishonesty. The plethora of ethical business codes with
unclear empirical content provide circumstantial evidence of this.
162 THOMSEN

5. Discussion

This paper has analysed ethical codes as a corporate governance mechanism and
the analysis was found to have both normative and descriptive implications for
ethical management. It was found that ethical business codes are especially likely
to improve social well-being if they concentrate on issues which are specific to the
individual firm. It was also argued that optimal firm specific ethical codes might
well differ from the prevailing social ethic. The paper finally pointed to some
Žimperfect. mechanisms which induce firms to adopt optimal ethical codes.
Although the paper has presented what is believed to be a new approach to the
analysis of business ethics, the analysis remains rudimentary in several respects.
For example, it has been confined to the standard economic definition of social
optimality Žefficient use of resources, none-wastefulness .. But it is clear that
business 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 particular
profit 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 for
the paper’s remaining shortcomings.
2. On the limitations of economic analysis applied to such profound questions see Radin Ž1996. and
Arrow Ž1997..
3. Most Western business codes explicitly rule out support for a political partyᎏe.g. IBM Business
Conduct Guidelines 2000.
4. A Danish pension fund, PFA, has adopted a set of ethical guidelines which prohibit investment in the
companies involved in the arms industry, child labour, human rights violations in the home country,
atomic power and environmental problems Žthe Danish business newspaper Børsen 22 May 1997..
Wher the fund was criticised in the media for holding shares in Phillip Morris and other tobacco
companies the company spokesman responded that the fund considered smoking a matter of
personal privacy Žthe Danish newspaper Politiken 6 August 1997..
5. Cf. Tirole Ž1988.: ‘‘ 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 to
fighting. Army 1, which is somewhat knowledgeable in game theory, occupies the island and burns the
bridge behind it. Army 2 then has no option other than to let army 1 ha¨ e the island, because it knows that
army 1 has no choice other than to fight back if army 2 attacks. This is the paradox of commitment: Army
1 does better by reducing its set of choices.’’

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