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 Teaching Note 2

Ethical Perspectives

This Teaching Note covers the following Learning Objectives: Learning Objectives:

1. Identify "self interest" and competing interests as applied to the business.
2. Identify key ethical frameworks
3. Identify the agency problem as a "moral hazard" and describe the principal-agency resolution that maximizes stakeholder interests.

Economic Theories of the Firm:

We are a social species, possessing a wide variety of organizational modalities ranging from the family to state government. The business firm is but one social type that we have evolved that has three defining attributes:

Economic function - The firm is a producer, transforming resources into marketable outputs, goods and services. In this sense, the business firm is the molecular unit of the economy.
Governance - The firm makes decisions to organize, control, and coordinate resources within its boundaries and externally forms associations with other firms as supplier, buyer, rival and ally.
Lawful existence - The firm is a "legal fiction". We treat the firm as if it had legal rights and we sanction its existence as if it had rights and obligations, in its external and internal transactions with respect to property, labor, and implied or expressed. Contractual relations.

Of these functions, the economic function, the ability to create value with private capital either invested or borrowed funds, separates the firm from most other forms of social organization. Government, for example, historically derives funds, through taxation, public money. The family unit can be "economic" unit, has a legal existence, and may differentiate roles for decision-making, but historically has played a dominant role in social organization. The firm differs as an organization in that it must find investors or lenders for financial operations. It depends upon others, customers for survival. And, in return for invested or loaned capital a business must promise or demonstrate an ability to yield financial rewards to investors and to return funds borrowed.

Since the firm has an economic function, theories of the firm attempt to explain how the firm transforms capital into returns or profits. In its simplest form, economic theories are of the form that we commonly understand as the General Accounting Equation:

Usually, when I write this equation, a student economist or accountant, recalls that economic profit is not the same as accounting profit. I want to simply note what this theoretical argument is about, before returning to the theories of the firm:

The debate is over the accounting equation’s use of costs to determine profit. To the accountant costs are explicit, that is costs represent funds paid out (or reserved) to acquire resources. Most economists, however, want to argue that costs also must include implicit costs. These are opportunity costs. An opportunity cost is the value of the best alternative use of resources that were given up to do something else. In the case of profits, the opportunity cost that is omitted in the accounting equation is the value of time and capital that are forgone to invest in the firm. So, a revised accounting equation from the economist’s perspective would show costs as equal to IMPLICIT + EXPLICIT COSTS. At times in this course we will return to the issue of opportunity costs. For now, to simplify the argument, accept that we will consider accounting costs as the same as the economist’s concept of costs.

There are many economic theories of the firm, some dealing with specific issues, such as the size of firms, the number of competing firms, or distinctions between owner-managed firms and firms owned by dispersed stockholders. But, commonly economic theories are divided into two broad categories:

Production theories.- In production theories, the central issue is to explain how firms use resources to generate profits. The assumption is that firms are profit maximizes. This assumption is necessary for a more general economic theory to work. That is, if the market is to be efficient and organize exchanges on the basis of the price mechanism, then the producers of goods and services must attempt to efficiently transform resources into outputs. Inefficient producers should incur higher costs than other producers; therefore, inefficient firms either provide goods that must be sold at prices higher than competitors, or goods are sold at the prevailing market price with costs higher than prices. In either case, inefficient firms should not survive. To survive, to grow, firms must maximize profits through efficient production with costs minimized. Efficiency of firms ensures that, in general, market prices are near production costs, as the auction process of supply and demand in competitive markets drive price levels to an intersection of marginal demand and costs. The assumption of this economic perspective is that firms are production entities that maximize profits.

Managerial theories.- Managerial theories are critiques of these assumptions, but oddly are theories created by economists. The critique may be that (1) firms do not maximize profits - they maximize other outcomes (such as sales); (2) maximization itself is not feasible, because decision-making is complex and made under uncertainty; or, (3) there are necessarily costs inherent in the ways that production is organized and transacted that are not considered in traditional economic theory. These theories are "managerial" theories because they draw attention to the reality that whatever firms do, they do at the direction of management. Firms are not merely production entities responding automatically to other producers and buyers in the market. Firms' managers make decisions involving a complex set of variables .

The Firm as a Production Function:

To understand the traditional economic theory of the firm, let us review the assumptions of perfect competition:

Resources are mobile, and information about resources is perfect and available. By this is meant that each firm has access to all resources at the same market price. All buyers and sellers know what the prices are and what the costs paid by others are.
There are many producers and buyers. No one firm or customer has an appreciable share of the market. Each buyer and seller acts independently. Rivalry is also impersonal. That is, the fortunes of one firm are not dependent upon the fortunes of another.
Over the long run no producer or buyer has a sustained advantage. Products are continuously variable in quantity. Over time, there is no "backlog" in supply or demand with each good being produced in lots that are demanded. The economists say that "markets clear", indicating that the market always finds an equilibrium.
It is assumed that products are homogeneous or undifferentiated. This is commonly understood to mean that of interest are firms within a single industry.

Under these conditions, the firm, the producer, has a fairly limited role. Adam Smith’s invisible hand of the market is working to maintain harmony. The firm cannot set prices - the market place sets prices. Success depends upon the ability of the firm to buy and combine resources most effectively. But, since the costs of raw materials and labor are also set by the marketplace, no firm has any particular advantage in the acquisition of resources. What firms do is decide how to combine resources most effectively, giving rise to the notion of the firm as a production function. The production function is simply a mathematical relationship that explains different possible combinations of resources that a firm may use to manufacture its product. The model permits the firm to choose a most efficient combination of resources that maximizes profits. So, the firm is confronted with choices about how to maximize profits, understands what choices are more profitable than others, and opts to maximize profits. The role of management is more akin to that of the engineer in determining the "right" combinations of resources for the "right" level of production. Organizational and managerial characteristics of the firms are not especially relevant.

Thus we come to the defining characteristic of the firm in economics: it is a producer that maximizes profits, converting available resources into outputs of greater value. In creating value firms seek to maximize the distance between revenues and costs. Remember: there is the problem of defining "costs" as opportunity costs. And, there is one other slight assumption we must make in talking about the economist’s view of "profits" that is different from our accounting understanding. To the accountant profits are realized in one year. To the economists the question of when profits must be realized, is ambiguous. But, I think, we can understand that a firm might not be profitable in a particular year, but be profitable over a longer period of time. So, the issue from an accounting and economic standpoint is similar: at some point when firms do not realize profits, they cease to exist.

There are problems with this theory of the firm. First, there is a theoretical problem: if firms are price takers, and the number of suppliers and buyers are numerous, how do prices for a specific good change? The simplest way to accommodate a need to explain that prices change is to relax some of the assumptions of competition, at least in the short term. For example, information may not always be perfect. Asymmetries (differences) in the amount of information that buyers possess about available offerings, permits one firm to temporarily raise prices without losing customers or to lower prices without taking all the customers.

Second, there is the problem of the economic assumptions. What if the assumptions that lead to competitive markets are not satisfied? In classic economics two such conditions are contemplated. Conditions in which there is only one producer - the monopoly - and, conditions in which there are few producers - the duopoly case in which there are two firms and the more general case of oligopoly. (In the business strategy literature, an industry that is competitive is termed fragmented and an oligopolist industry is termed a consolidated industry.) Under monopoly, one firms controls the industry. The firm can chose either the price at which it will produce or the amount of goods it will produce. Typically, the monopolist is assumed to choose how much it will produce, setting the level of supply where profits are highest. The theory of the monopolist is that it, like the competitive firm, is a profit maximizer.

In the "real world" we rarely encounter the economists’ monopoly. Usually when we find a monopolist, such as a cable TV company, we have the option of substitutes - buy the new satellite system or do without CNN. Moreover, monopoly is simply illegal; and, in the "real world" this typically leads to some kind of public regulation as a substitute for market competition to limit price gouging. The economists’ perfect competition is also rarely found. Industries have a varying number of firms; and, firms within an industry are associated with a varying number of buyers. Buyers and suppliers tend to be finite, and the variations of firms and products across industries produce specific industry characteristics. This permits us to observe that competition across industries differs - some are more competitive that others. "Real" industries lie somewhere between the economist’s monopoly and perfectly competitive market - as the data below demonstrate:

SIC Code: Standard Industry Classification
CR(4): Concentration Ratio or % Market Share for the 4 largest firms No. of Firms: US based firms only

Real markets are oligopolistic: industries are populated by a finite, but varying, number of producers; and, firms differ in market share. If we assume that profit maximization operates, each firm attempts to maximize profits but discovers that when production is increased, the ability of other firms to maximize profits is adversely affected. There is only so much demand for the goods produced. One firm can benefit only at the expense of another. In this model of competition, unlike the case of perfect competition, firms in an oligopolistic market are interdependent.

Firms are interdependent in the sense that when a firm attempts to gain an advantage by increasing production this act affects prices for all firms and, of course, leads to less profits. Other firms reassess their own production decisions - they retaliate. This case is familiar to us when gas stations on opposing corners of the street decide to improve profits by lowering the price of gas. A gas price war follows. To minimize this eventuality a firm must anticipate the impact of its decisions on other firms. As a consequence, firms under oligopoly do not just maximize profits, they seek to maximize their understanding and perception of what their greatest, safe profit level can be. If their judgment is wrong, other firms will retaliate and attempts to maximize profits will be frustrated. An equilibrium of the market can be created (1) by firms colluding to set prices (illegal under anti-trust laws) or (2) by all firms in the market holding beliefs about the consequences of their actions - that is: understanding how rival firms will respond to attempts to gain an advantage which are verified by subsequent actions. This is termed "market discipline".

To analyze competing firms under conditions of oligopoly, many economists model the market using game theory. Game theory is a mathematic formulation of competition that assumes that rivals are interdependent. Commonly, a zero-sum game is modeled in which one player wins at the expense of other players. A non-zero-sum game assumes that each firm can maximize rewards without harm to other rivals. Game theory as a model of real markets can be useful in understanding how competition works; but, the mathematic assumptions required to produce solutions limit game theory’s application to real business scenarios.

Managerial Theories of the Firm

Note that all our discussion of the firm in economic theory has tended to focus more on markets than on something called a "firm". The firm has been conceptualized as an economic producer that maximizes profits and simply decides how - by varying either how it will combine resources or, as under oligopoly, the level of goods that it will it produce. This seems incomplete in explaining the business enterprise as most of us have come to understand business. Firms have a variety of characteristics that seem to be important to profit-making: size, management, organization, even motivations other than profit making.

As we have seen, the modern firm differs in important respects to the traditional firm. The traditional firm was a proprietor-manager’s asset. The modern corporation is owned by a large group of stockholders, but managed by a group of professional managers. The modern firm operates in multiple markets, not one. Managerial theories of the firm attempt to take these modern aspects into account and the focus is on the firm - not markets. We will concern ourselves with four such theories, that broadly represent the areas of concern for this course:

Robert Marris’ theory of the difference in motivation between owners and managers, and, the more generalized formulation - Agency Theory, which is a broad literature examining the relationship between owners and managers; Transactions Costs, which views the firm as an alternative organizing mechanism for the market and imputes a hypothetical cost on such transactions as making and enforcing contracts to explain why some organizational forms are more efficient than others; Stakeholder Theory, which define the firm in terms of competing interests held by owners, managers, employees, customers, and suppliers.

Marris’ Theory

Since the owners of a firm are diverse, usually dispersed, stockholders, who are motivated by profit-maximization and return on their investment, how can we resolve the problem that the decision-making of the firm is by managers who may not share the same motivation? What are the motives of managers? A number of different motives have been assigned to managers by economists:

Scitovsky - assumed that the manager attempted to maximize his own personal income and his leisure, or time not spent managing the firm
Baumol - assumed that managers attempted to maximize their own salaries which are linked to the firm’s sales; so, managers maximize the firm’s sales, not its profits. This leads to growth of the firm through the manager’s efforts at increasing sales.
Galbraith - argued that managers have become increasingly technocratic, building larger businesses that are more and more technologically based, at the sacrifice of investor interests in profit maximization and displacing the interests of labor in job security and of society in full employment.

In Marris’ theory the manager maximizes business growth and personal security. The manager wants the firm to be large, because managers of large firms enjoy higher salaries and higher status. Managers attempting to grow the firm encounter a peril: if the firm overextends itself it will be taken over by a rival. The manager will be redundant, and lose his job. He must maximize growth and avoid the takeover. The manager must pursue a course of sustainable growth while avoiding the prospects that another firm or group of investors will merge or acquire the business.

To understand this peril, we have to examine how Marris believes takeovers work. This has to do with how firms are valued. Two types of valuation are considered:

Book Value is the accounting value of the firm. It is the recorded value of the firm’s assets owned by the owners, "Equity". A firm can grow naturally by selling goods, controlling costs, realizing high profits, and using retained earnings to grow. This process is explained by the general accounting equation: ASSETS = DEBT + EQUITY + (REVENUES - COSTS).
I will not go into the accounting methods for determining the Book Value, but, fundamentally, it is historically determined to be the value of what is invested ("Booked Equity"). Book Value grows as Equity grows. Equity grows as the firm creates profits and retains profits for re-investment in the firm.

In Marris’ theory managers desire to increase book value because this means growth. Managers would rather manage a larger firm than a smaller one, because managers of larger corporations make more, and have greater amenities, including status.

Market Value is the value of the firm as determined by the stock market. Simply, it is today’s stock price times the number of stocks. It is what investors are willing to bid to own the firm. This value is determined in complex ways, but we will assume that an investor considers the opportunity costs of alternative investments, and decides that the stock price is a rational value to bid to own a firm - taking all information, including the future prospects of the firm, into account. Market value increases to the extent that expectations about future growth increase. An investor seeks to increase market value because the investor will seek to sell stock at a price appreciably higher than the price at which the stock was acquired.

In the theory, takeovers are predictable by examination of the ratio of these two values, Market to Book value (M/B):

IF M/B = 1, then market investors believe that the firm’s value is simply equal to the value of what has already been invested. The future prospects of the firm have no extra value.
IF M/B > 1, then market investors believe that the firm’s future prospects are high. The firm is worth more in the future than what earlier investors paid. The stock price is high than a unit of book value. The firm will grow and current investors make money. If current investors sell stocks on the market, they earn money because the current stock price is higher.
IF M/B < 1, then market investors believe that the future prospects of the firm are not good. They bid a stock price that is less than the book value. The capital invested in the firm is not as productive as it ought to be, or could be if invested elsewhere. This is a takeover situation. The firm can be bought at a price less than the worth of the assets it represents. The firm will be bought because, with a change in management, capital can be made to be productive. Profits can be increased. Stock price can be improved.

For an owner-managed firm, the firm can seek to maximize Book Value without fear of a takeover. But, for the modern corporate enterprise, management is motivated to avoid situations in which Market Value falls below Book Value, least the firm be taken over and management replaced. To maximize Market Value so that it stays above Book Value, the manager must pursue growth by increasing sales, but this is constrained by the need to pay current stockholders (owners) a dividend. Dividends are important because it is one way owners receive a return on their investment, and dividends help maintain the market value of the firm’s stock. When dividends are paid out, however, profits are not retained for growth of the firm. early growth increases profits, but as the firm grows, future growth and profit increases are possible only at lower growth rates. Growth and profit-making cannot be sustained continuously - market value will be depressed.

Retained earnings, is of course not the only way to finance growth. A firm can borrow money, or increase debt; and, a firm can simply issue new stock. The problem with debt financing, or "leveraging", is that debt must be paid back with interest. When growth produces profits there is no problem. But, the greater the debt the higher the risk that at some future date profits will not be sufficient to repay debt with interest. The estimate of what future profits might be, sets an upper limit on how much can be borrowed. Debt financing also influences market value, because investors discount debt and debt risks in their bids, the current stock price. So, use of debt to grow does not appreciably change the analysis of Market to Book ratio. Similarly, issuing new stocks to finance growth does not affect the theory. If the firm issues 10% new stock, it would have to increase profits by 10% to maintain the current Market to Book ratio.

In Marris’ theory, it really does not matter how the firm secures capital. Management must pursue growth by increasing sales, but must ensure that the investors’ interest in value creation is satisfied. To ignore this is to jeopardize the manager’s job security.

AGENCY THEORY

In law an "agent" is someone who acts for another, called the "principal". In this relationship the agent is required to act in a fiduciary and responsible fashion - acting in the interests of the principal. We could say a "contract" exists between the manager and the owners. When we apply this legal relationship to managers, the manager is legally a paid agent of the owners or stockholders, the principals. But, people behave rationally - in their own self-interests. Investors seek to maximize profits and the value of the firm. The motives of managers are not necessarily those of the investor. Managers are influenced by a complex of competing pressures: employees and their unions, the media, customers, community agencies, conflictive organizational interests, and personal objectives.

The proclivity to stray from the principal’s interests is called "the agency problem" and the perspectives that offer understandings of this problem are called "agency theory".

The agent enjoys some autonomy and independence from the principal. This follows from the fact that an agent is hired because he or she has specialized knowledge and skills. In the case of the manager this autonomy from the owners is increased because the owners are not involved in the day to day operations of the business. This means that owners do not have access to specific and important information about the business, information that is routinely available to the manager. The greater the independence that the manager enjoys. The more the owner is dependent upon the manager to act in accordance with the owner’s interests.

This relationship presents a moral hazard, a term from insurance contracts that describes a situation in which the writing of a policy can create an incentive for the policy holder to cause an accident, such as arson or a fraudulent claim of theft. The moral hazard arises through the asymmetry in information available to the agent and principal.

There are two ways to minimize the moral hazard

(1) the principal can monitor the actions of the agent
(2) the principal can reward the agent for meeting his responsibilities and acting in the interests of the owners.

Monitoring is what management does. Management monitors the actions of other contracted parties - workers - to ensure that they are behaving in the interests of the owners of the firm. The problem with monitoring, if it is stockholders’ monitoring top managers or managers monitoring workers, is that it is difficult and costly. The Board of Directors is a vehicle for stockholders that is supposed to monitor management; but, directors are not intimately involved in the daily operations and may not be especially knowledgeable of the all the aspects of the business. From a cost perspective it is not rational to duplicate the effort of the contracted agent.

This brings us to the second solution: rewards. If the rewards of complying with the interests of the principals exceeds any benefits of an agent acting in personal interests, then the agency problem is resolved. There are three well known alternatives using rewards:

Pay the manager a very high salary;
Make the manager an owner of the business, a shareholder; and,
Make the manager also a member of the Board of Directors. Members of Boards are classified as:

1. Inside Director - a Member of the Board of stockholders who is also an officer or manager of the firm
2. Outside Director - a Member of the Board who is only a stockholder

COST TRANSACTIONS THEORY

The question Ronald Coase posed in 1937 was "Why a firm emerges at all?" The market system as an efficient allocater of resources ought to operate without the need for organized attempts to coordinate and control the details of production. To illustrate the problem confronted by Coase, I use the case of moving household effects:

When I decided to move to Hampton from Philadelphia, I confronted the problem of moving my household goods. The economy provided me two distinct alternatives: I could use the market mechanism and view moving as a number of individual transactions. Under this alternative, I would purchase labor to pack my goods; hire a truck and driver to transport my goods; and, in Hampton, hire labor to unpack. For each of these transactions, I would use the market mechanism - an auction - to determine my costs. In Philadelphia, I would pay the spot labor market price for wage labor, depending on how many people were available to do the work of packing and loading and depending on the Philadelphia demand for their services. Similarly, a driver and truck could be obtained through an auction process involving phone calls and newspaper ads that solicited the lowest bid for this service; in Hampton, the local labor market would decide how much I would pay to off-load my goods. The sum of each of these steps would be my cost of moving.

The alternative was to call a moving company. This is an organization that coordinates and controls all of the exchanges for me. Since there is a market or industry for moving firms, I would shop for the best price and service from all rivals.

I investigated both of these alternatives. The cheapest way for me to move was to "do it myself".

So, why is there a need for something called a moving company if I can perform all of the transactions required in the act of moving, especially if the alternative of the moving firm is more expensive? We could extend this argument to all transactions: why don’t we let market mechanisms set efficient, lowest prices for all goods and services which we directly consume in ways appropriate to their end use?

The observation that we do not infers that that are costs involved in using the market price mechanism. Organizing exchange processes through the firm must offer some efficiencies that do not exist in market exchanges. Sometimes these organizational efficiencies exist, sometimes the market mechanism is more efficient than firms. We now confront the problem of transactions costs.

These transaction costs arise from several sources. For example, in my moving case, a series of contracts, first and lastly, with independent labors to pack or unpack, and with a driver and a truck. involved costs of my time, both in identifying useful resources, negotiating the contract for services, and in management of the work performed. More generally, the act of establishing a contract between a buyer and a seller involves transaction costs, the costs of obtaining reliable information, the costs of negotiations, and the costs of paying and settling financial dealings. For me, the issue of using a firm or the market place in this exchange is: Are the transactions costs high enough to offset the higher price of the moving firm? There is a sufficient number of buyers for which the answer is "no", because there is a demand for moving company services. The firm provides the coordinating and controlling of this series of exchanges and incurs the transactions costs to offer a marketable service for a "packaged" price.

The problem with transactions costs can also be illustrated from the perspective of the laborer. Why would anyone work for a moving firm? From traditional economic theory, the price of labor, the wage rate, is determined in a spot market - today’s demand for and supply of labor. The laborer, then. confronts a price of his work which fluctuates day to day, season to season. A laborer who is productive, knowledgeable of who is moving and when, and knowledgeable of the available supply and demand, could position himself to earn a high wage rate by being available when someone needed the service and offering his service at a price slightly lower than the price of using a company to pack and load goods. The laborer faces a problem similar to mine: the costs of information (knowing who is moving and where they are located, knowing what the current market price for his service is), and the costs of the transaction (negotiating a fair contract and collecting the money). Also, the laborer, and I, confront seasonal fluctuations in market prices. People move in large numbers at the end of the year and in late summer. Prices are high in these periods. Low at other times.

The laborer seeks attachment with a firm that assumes the information and transactions costs, and the laborer trades-off high and low fluctuations of income for a steady, predictable steam of income as a salaried employee - working for a company reduces the risk costs of self-employment. To resources, such a laborer, there is an efficiency in the organizational activities of the firm that in some transactions make the firm more efficient than the market place in organizing economic activities.

The problem with transaction costs is that they are tough to measure, often intangible and hidden. What is the cost of obtaining relevant information? Transactions costs does extend the general economic paradigm, however, by attempting to examine organization as a form of market. The distinctive characteristics of the firm compared with the larger market place are:

hierarchy - there is a layer of decision-making in which activities are controlled in some purposeful way; by contrast, in classic economic theory decisions are made by the market of many autonomous buyers and suppliers.
fiat - resources, including labor, is exchanged and transacted via authority of a manager, not through a market price mechanism
boundaries - a firm is a legal entity, in which a nexus of contracts exists: between shareholders and manager, between manager and workers. By contrast, in classic economic theory, the relevant boundary is a market place is defined by are buyer and suppliers of a product.