Conspicuous By Its Absence: Ethics and Managerial … By Its Absence: Ethics and Managerial Economics 1. Introduction Over the past few years I have been collecting a series of vignettes

Conspicuous By Its Absence: Ethics and Managerial Economics

Daniel G. Arce M.* Robert D. McCallum Professor of Economics & Business

Rhodes College 2000 North Parkway Memphis, TN 38112

[email protected] 901/843-3121 (o) 901/843-3736 (f)

Abstract This paper gives prescriptions for introducing ethical concerns into the economic theory of the firm. Topics include social responsibility, corporate governance, profit maximization, competition barriers, collusion, the market system, and welfare economics. The need for such prescriptions is based on a content analysis of 21 managerial economics texts for their coverage of ethics. My analysis finds that substantive discussions of ethics are conspicuous by their absence. This finding is also consistent with the (lack of) coverage of business ethics in economics journals. As ethical breaches can involve significant monetary damages to a firm – particularly through adverse market reactions – moral-reasoning abilities can complement analytical skills. Consequently, my analysis demonstrates how ethics figure into the opportunity costs of managerial decision-making, which is central to the economic definition of profit.

* I have benefited from conversations with LaRue Hosmer, Mark McMahon, Paul Pecorino and Kevin Siqueira. The opinions expressed within are strictly my own.

Conspicuous By Its Absence: Ethics and Managerial Economics

1. Introduction

Over the past few years I have been collecting a series of vignettes related to economists’

experiences with ethics in the classroom. Consider yourself in the following situations, all of

which have a grain (or more) of truth:

You teach managerial economics at a business school in a large state university. All of the seniors in the business school must participate in teams in a simulated production economy as a capstone experience. During final exam week it is discovered that the simulation has been corrupted because one team successfully organized a cartel. When asked to explain their behavior, the participating seniors reply that they were employing techniques of tacit collusion taught in your class. While there is time to take disciplinary action against those who participated in the cartel, their behavior has influenced the game and hence the grades of all graduating seniors. There is no time to run the simulation anew. In the meeting to decide how to assign final grades, your Dean asks, “Did you discuss antitrust legislation in class when you covered tacit collusion? 1 Further, did you discuss the ethics of such behavior?”

You teach intermediate microeconomics at a small liberal arts college. You show up for your (optional) final exam but none of your students do. You believe that it is an honest mistake about when the final is scheduled. Later in the day you run into one of your students and she explains that there was no mistake, “We have been together for almost 4 years now. In studying for the exam we came upon the idea of a ‘no final exam cartel.’ We just agreed that if someone showed up for the final, then we wouldn’t invite them to any more parties. As you have been encouraging us to apply economics out-of-the-box, we thought that you would understand this application of cartel behavior.”

You teach in an EMBA program. After introducing the concept of extensive form games, you cover the textbook example of the “poison pill” as a credible method for deterring hostile takeovers. Once your example is completed, a student asks how they are to interpret your lesson, given that a recent Wall Street Journal article (Langley 2003) has highlighted that the availability of a poison pill takeover defense will have deleterious effects on a firm’s corporate governance score, as measured by the Institutional Shareholder Service, Inc (ISS). The ISS rating system is used by about 200 of the nation’s largest corporations, several of which are represented in your classroom. How do you respond?

The continued AACSB certification of your business school requires ethics as part

1 In antitrust jargon, tacit collusion is a form of conscious parallelism and may be prosecutable subject to a rule of reason as to its anticompetitive effects.

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of the curriculum. There are two options: a stand-alone course or integrating ethics in diverse areas of the curriculum. Your Dean opts for the latter and you are instructed to include ethics in your managerial economics class. Where do you begin? As table 1 reveals, it will be difficult even to select a textbook to assist you in this task.

Issues related to the ethics of the material taught in managerial or micro economics can hit

close to home. Moreover, how are students to make ethical judgments about economic decisions in

the workplace given the lack of coverage in the literature and textbooks?2 Teaching tacit collusion

is different from endorsing it, but discussing related legal and ethical issues places such behavior in

proper context. Further, Roy E. Moor (1987) – former president of the National Association of

Business Economists – argues that a firm’s economist should logically be its ethics officer, given

economists’ comparative advantage in understanding markets and tradeoffs.

Beginning at least with Braithwaite (1963), a considerable literature exists on how economic

tools shed insight on the philosophical analysis of ethics. By contrast, my emphasis is on the ethical

issues inherent in economic subjects that managers find of use. That is, there is no need to go

outside of economics and teach Aristotle, Rousseau, etc., because the ethical issues that arise in

managerial economics are as endogenous as the solutions to resolving them. This paper offers

examples of how ethical issues can be integrated into topics that are typically covered in a

managerial economic class. I call such examples “teaching moments.” An in-context or

integrative approach to ethics best illustrates the diversity in which such issues arise. The purpose

of business ethics education is to develop and enhance moral reasoning abilities and to demonstrate

how this complements analytical skills (Prasad et al 1993). The integrative approach reinforces the

2 An examination of the EconLit database reveals that only 6 of articles on business ethics were published in the top 15 economics journals from the period 1986-2002/06 (this period was selected to exclude any bias that may occur due to the current ‘ethics bubble’). A conservative estimate would be that these journals published over 6,000 articles during this period. Further, if one examines the top 20 economics journals devoted to business issues, the count is 4 articles total on business ethics over the same period. These counts do not reflect articles that are about issues such as social norms, reciprocity, etc. It is my contention that if ethics is not a keyword identifier for an article, then the focus is elsewhere. Further, issues of individual ethics are not necessarily the same as business ethics.

Table 1: Content Analysis of 21 Managerial Economics Textbooks1

(% of Texts)

Category (1)

Listed in Index

(2) Extent of Coverage

(3) Positive

Justification

(4) Ethical

Coverage

(5) Legal

Coverage

Ethics2 29% 1 ¶, 1 pg, 2 pgs, 2 pgs, 5 pgs, 1 Chapter

Social Responsibility3 14% 1 ¶, 2¶, 1 pg, 2 pgs, 3 pgs, 4 pgs

Governance4 38% 1 Box, 1 pg,

3 Boxes, 6 pgs, 1 Chapter, 2 Chapters

Firm Objectives5 100% 58% 5% n/a Competition Barriers 6 100% 100% 24% 90% Collusion7 100% 100% 5% 81% Market System8 100% 38% 10% n/a Welfare Critera9 100% 58% 10% n/a 1 Textbooks are listed in the appendix. 2 Keywords: business ethics, code of ethics, corporate ethics, managerial ethics, morals, morality. 3 Keywords: Milton Friedman, socially desirable, social contract, stakeholders, stewardship, whistle blowing, values. 4 Keywords: adverse selection, agency, asymmetric information, (executive) compensation, corporate governance, Fisher separation,

moral hazard, principal-agent. 5 Keywords: profit maximization, revenue maximization, shareholder (stockholder) responsibility, shareholder (stockholder) wealth

maximization. 6 Keywords: advertising, antitrust, barriers to entry/exit, block pricing, bundling, competition law/policy, entry deterrence, limit

pricing, penetration pricing, predatory pricing, price discrimination, price skimming, quantity discount, regulation, rent seeking (lobbying), resale price maintenance, restrictive trade.

7 Keywords: antitrust, auction rings, cartels, cooperation, legal(ity), price fixing, regulation, restrictive trade, tacit collusion. 8 Keywords: auctions, bargaining, J.K. Gailbraith, invisible hand, Adam Smith. 9 Keywords: cooperation, distribution, equity, fairness, golden rule, justice, Pareto efficiency/optimality, John Rawls, social welfare

function, utilitarian, welfare economics.

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notion that very little in managerial economics is void of ethical content.

The paper proceeds as follows. Section 2 briefly surveys how several Nobel laureates in

economics have addressed business ethics, beginning with Friedman’s (1970) article on the

social responsibility of the firm. Section 3 details my method for conducting content analysis

(Weber 1990) on the ethical content of managerial economics texts (listed in the appendix). I

focus on managerial texts because they most directly fall under the AACSB ethics imperative.

Further, in many MBA programs students may never take an introductory economics course, so

managerial economics is likely to be their only exposure to the ethics of economic decision-

making. Although intermediate microeconomics texts are also used in this course, examining

managerial texts is sufficient to gauge the state of ethical focus (or lack thereof). Section 3

consists of eight subsections corresponding to the ethical and economic categories of my content

analysis. Each subsection is concluded with several “teaching moments” – examples of how

ethics are pertinent to economic decision-making for the tactic/issue under study. Section 4

contains brief concluding remarks.

2. Nobel Laureates and Business Ethics

Much of the normative hand wringing with respect to ethics in economics arises from the

widespread – albeit inaccurate – belief that Milton Friedman’s (1970) classic article in the New

York Times Sunday Magazine, “The Social Responsibility of Business is to Increase Its Profits”

equates social responsibility with ethics. Friedman criticized the notion of social responsibility

as it applies to issues such as constrained pricing to prevent inflation, reducing pollution beyond

the regulated amount, hiring the “hard core” unemployed, etc. Reading past the title to the fourth

paragraph finds Friedman stating,

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That responsibility (of corporate executives) is to conduct the business in accordance with their desires (of owners and employees), which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom (p.33, emphasis added). Arrow (1973: 309) similarly defines a firm’s social responsibility in terms of its ethical,

moral, and legal obligations. Social institutions such as regulations, taxes, laws, and ethical codes

prescribe these obligations. Such institutions are necessary because the argument for unabated profit

maximization breaks down when firms produce externalities (e.g., pollution or congestion) and/or

situations of asymmetric information exist between buyers and sellers (moral hazard or adverse

selection). Taxes and then regulation are Arrow’s pecking order for internalizing externalities. By

contrast, he asserts that ethical codes best increase efficiency under asymmetric information:

A close look reveals that a great deal of economic life depends for its viability on a certain limited degree of ethical commitments. Purely selfish behavior of individuals is really incompatible with any kind of settled economic life. There is inevitably some element of trust and confidence (p.314).

Ethical behavior can reduce transaction, contracting, policing, and enforcement costs

through the use of verbal contracts, incomplete contracts, and policies that promote honesty. This

latter concept is what Sen (1987) labels as agency – aspects of individual motivation that arise from

doing certain things, rather than enjoying the actions’ consequences.3 The freedom to form goals,

commitments, values, etc., cannot be entered into a decision maker’s utility func tion without

rendering it tautological. Yet these aspects of agency motivate individuals and influence their

actions. For example, it is widely known that what influences employee satisfaction more than pay,

promotion, and benefits is the confidence that higher-ups are making good decisions (Jenkins 2003).

It is entirely possible for an employee to understand that the consequences of a manager’s decision

will be to his/her financial advantage, and still the employee’s satisfaction decreases because he/she

3 Outside of this paragraph we refer to agency exclusively in terms of corporate governance (Berle and Means 1932).

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understands that the decision or decision-making process is flawed or unethical.

Arrow (1973) further argues that even in its most ideal form, the forces of perfect

competition are not sufficiently vigorous to remove it from ethical context. For example, there is

the question of unequal income distribution that comes from unconstrained profit maximization.

Indeed, the “invisible hand” metaphor that economists are familiar with was not only intended by

Adam Smith to be responsible for the functioning of the marketplace, but also for civil ethics

(Evensky 1993, 2001). It is the coevolution of individual and societal ethics that leads to the

stability of classic liberal society. In Smith’s view, the benefits of a laissez-faire society can only

be realized when there is no need for government intervention because its citizenry voluntarily

follows the dictates of civil ethics (Evensky 2001: 506). To wit: Adam Smith not only wrote The

Wealth of Nations, but also The Moral Sentiments, and the two are conjoined.4

Buchanan (1992: 402) similarly argues for research that incorporates the interdependence

between dynamic market performance and ethical norms. He sees the economic theory of ethics as

seriously underdeveloped in comparison to the economic theories of law and politics. Both Smith

and Buchanan recognize the need for ethics because unbridled self- interest is likely to produce

leviathan. By contrast, free markets are stable and self-regulating when populated by an ethical

citizenry. This is because market exchanges are both voluntary and repetitive. Hence, as Stigler

(1981: 171) remarks, “Because they are repetitive, they (usually) make deceit and nonfulfillment of

promises unprofitable. A reputation for candor and responsibility is a commercial asset – on the

enterprise’s balance sheet it may be called good will.” Indeed, ethical behavior is an implicit

assumption in the majority of texts. Market imperfections such as monopoly, adverse selection, and

moral hazard are standard topics whereas theft, coercion, fraud, etc., are generally omitted.

No less than five Nobel laureates and the father of modern economics recognize the 4 Examples of Smith’s moral sentiments include sympathy, fairness, gratitude, friendship, duty, and prudence.

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importance of ethical behavior for the functioning of the marketplace, and ethical behavior within

firms for productive efficiency. Yet how does this translate into the economic theory of the firm?

This is the subject of the following section.

3. Content Analysis and Teaching Moments

In this section I provide the results of a content analysis of the coverage of ethics and ethics-related

issues in managerial economics texts. Content analysis is a research method that uses a set of

procedures to make valid inferences from text (Webber 1990). While its use has yet to become

widespread in economics, content analysis has been successfully employed by Chappell et al (1997)

to code textual records of the Memoranda of Discussion of the Federal Open Market Committee and

estimate reaction functions of members. Similar also to my analysis is McCloskey and Ziliak’s

(1996) assessment of whether empirical articles published in the American Economic Review during

the 1980’s correctly distinguished economic significance from statistical significance.

The content analysis centers on nine code categories: ethics, social responsibility,

governance, firm objectives, competition barriers, collusion, market system and welfare criteria,

listed as rows in table 1. Each category also contains a set of related keywords. For example, the

governance keywords include adverse selection, agency, compensation, corporate governance,

executive compensation, Fisher separation, moral hazard, and principle-agent. These terms were

among those where ethical content pertaining to the issue of corporate governance might be

found within a text. I then read the entire index and table of contents of each text to find where

these (and other related topics) could be located within the text. I read the texts and constructed

a keyword-in-context (KWIC) table of the content and context for each keyword corresponding

to a category. Table 1 is an aggregation of my text- level data.

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The first column of table 1 indicates whether a category or its keywords are listed in the

index of these texts. For example, in checking for texts that cover ethics I searched the index of

each textbook for the keywords ethics, business ethics, code of ethics, corporate ethics, managerial

ethics, morals, and morality. I also read the entire index of each text in case other relevant terms

appeared. Columns 2-5 summarize my KWIC analysis for each category. The categories are

divided by two different measures of intensity of concern. The intensity of ethics, social

responsibility, and governance is measured quantitatively in terms of the number of paragraphs

(¶), pages, boxes, and chapters devo ted to each. A quantitative measure applies because these

topics rarely appear in managerial texts; hence, it is useful to know the extent of coverage when

they do appear. By contrast, the remaining categories appear in all managerial texts, and a

qualitative measure is needed to identify whether the coverage is strictly positive, addresses the

ethics of the issue, its legality, or some combination of the three. For example, a text could cover

how price discrimination increases producer’s surplus (positive), its legality under the Clayton

Act, and consumer reaction to various legal forms of price discrimination (ethics).

The results of this content analysis are discussed below. Each subsection corresponds to

a category in table 1 and is also labeled by the keywords used to conduct the KWIC analysis on

each category. Each subsection is concluded with a series of “teaching moments” where specific

examples of ethical content are covered. Addressing the ethical issues of pricing, collusion, etc.,

at the moment they are introduced in class heightens student awareness of the tradeoffs such

actions entail. The teaching moments demonstrate that there are myriad ways in which ethics

modify the economic theory of the firm, but which are largely ignored.

3.1 Ethics: business ethics, code of ethics, corporate ethics, managerial ethics, morals, morality. Ethics is the study of how the moral responsibility of the individual transcends narrow self-

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interest. Just as an employee’s contract with a firm is an agreement to recognize authority and

hierarchy within it, the contract is also an agreement to adhere to the firm’s ethics. For this

reason, it is important for the firm to articulate its ethics so that the differences between individual

and business ethics are distinguished and remedies can be provided if the two conflict. Given that

economists regard their discipline as establishing the foundations for all business-related

decisions, the managerial economics course is a natural context for identifying and discussing

ethical tradeoffs and remedies.

In practice, however, the vast majority of texts surveyed (71%) do not contain ethical

content, as indicated by the first column of table 1. This is all- the-more perplexing when turning to

the content of those texts that do discuss ethics. These contain statements such as, “a study of

managerial objectives and incentives would not be complete today without reference to the subject

of business ethics” (Nellis and Parker, p.209), and “unethical behavior is neither consistent with

value maximization nor employee self- interest” (Hirschey, p.4). The coverage given in Brickely et

al is the most thorough, consisting of a complete chapter on business ethics. Paradoxically, their

focus is primarily positive, in terms of the interrelation between organizational design and business

ethics. For example, they emphasize that Enron’s flaws were in organizational design (p.2), but

also stress that questioning, “Is it legal?” does not suffice as a test of ethical behavior (p.613).

3.1.1 Ethics Teaching Moment

For my first teaching moment, Maital (1994: 49-50) describes an instructive tradeoff. He

presents an “Alan Dershowitz production possibilities frontier” (PPF) that corresponds to the

Harvard law professor’s discussion of the tradeoff between ethics and tactics in his third-year

course on courtroom tactics. The PPF is linear and downward sloping, indicating that maximal

tactical effort requires minimal ethical conduct. For Dershowitz, tactics and ethics are the critical

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tradeoff facing any criminal lawyer, and therefore for any client selecting a lawyer. Yet the choice

of lawyer rests with the client’s values, which are largely centered on winning the case. As tactics

are better served for this purpose, criminal lawyers should place the client’s interest over their own.

Whereas Dershowitz identifies the ethics/tactics tradeoff as critical for trial lawyers,

many managerial texts lack formal recognition of the tradeoff. Yet failure to recognize the

importance of ethics can be extremely costly. Corporate sentencing guidelines provide for a

60% reduction in fines if a company instituted an extensive ethics program prior to the offense.

More to the point; however, is that BCCI, Enron, Andersen, WorldCom, Global Crossing, etc.,

are all examples of firms that faced ethical penalties – in the form of adverse market reactions –

that are far higher than any legal penalty that can be imposed on them. We would surely

condemn a manager for failing to address non-ethical tradeoffs of this magnitude.

In considering the ethics of tactics available to firms, Hattwick (1986: 88) suggests

consideration of Rotary International’s Four Way Test: Is it the truth? Is it fair to all concerned?

Will it build good and better relationships? Will it be beneficial to all concerned? Similarly, the

International Chamber of Commerce (ICC) publishes rules of conduct for marketing and

advertising practice, corporate governance, e-commerce, etc., and makes these available to

educators for free upon request. For example, in their rules of conduct for corporate governance

the ICC asserts that what ultimately counts are rock solid principles and people with integrity.

3.2 Social Responsibility: Milton Friedman, socially desirable, social contract, stakeholders, stewardship, whistle blowing, values.

The coverage of social responsibility in texts is commensurate with Friedman’s opinion that a firm

should focus on profit maximization. Only 14% mention social responsibility. Among these, the

largest coverage is given in Brickley et al. They provide a subsection summarizing Friedman’s

article, correctly pointing out that social responsibility should not be confused with ethics. From

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this perspective, if the corporation focuses on maximizing shareholder wealth, then shareholders

and employees can set their own social agenda with the personal wealth gained from this objective.

Other texts that mention social responsibility merely state that it is beyond the scope of the text.

There are areas where the notion of social responsibility indirectly arises. Such topics

include the environment, environmental protection, product safety, and public interest. I conducted

a separate KWIC analysis on each these keywords. For example, Salvatore (p.487) remarks that it

is now clear that regulations enforced by the EPA have sharply reduced the level of air pollution in

some of America’s largest and most congested cities. Firms face regulatory environmental

constraints, and these tradeoffs are recognized in 58% of texts surveyed. Yet, there is no

recognition of the concept of environmental stewardship – the topic is as much of a non-starter for

economists as the notion of tradeoff is for most environmentalists (The Economist 2002).

3.2.1 Social Responsibility Teaching Moment

Business ethics can strike a middle ground by addressing the tension, rather than simply the

tradeoff, of the moral obligation of business within a society. Indeed, it is instructive to note that

firms that must actually bridge this tension cannot do so by specifying a unique objective function.

In his analysis of Shell’s 1998 report, Profits and Principles, Graafland (2002) identifies at least

four objective functions for Shell. If π denotes a firm’s profits, ε its ethics/moral principles, and

V(π ,ε) a value function over its profits and principles, I state these four possibilities as:

(i) Unconstrained optimization: “We believe fundamentally that there does not have to be a choice between profits and principles in a responsibly run enterprise” (She ll 1998: 3). This corresponds to the programming problem of:

επ ,max V(π ,ε).

(ii) Friedman doctrine: “To continue, it is essential to have endorsement from society – what some call a ‘license to operate’”(Shell 1998: 29). To wit:

ε,max⋅

π(⋅,ε) s.t. ε ≥ ε .

(iii) Stakeholder: “Profits are essential to sustain a private business: without profits to re- invest, a business ceases to exist and contributes nothing. They enable us to fulfill our social and environmental obligations” (Shell 1998: 9). That is,

π,max⋅

ε(⋅,π) s.t. π ≥ π .

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(iv) Profitably and sustainability constrained: “Sustainable development is about balance and integration. Integrating the economic, social and environmental aspects of everything we do” (Shell 1998: 3);

επ ,max V(π ,ε) s.t. ε ≥ ε , π ≥ π .

Given the complexity and diversity of Shell’s markets, competing descriptions of its objective

function are likely to be inevitable. At the same time; however, problems (i)-(iv) look no

different from others found in managerial texts and their study guides.5 Further, they produce

outcomes and comparatives statics that can be investigated empirically.

3.3 Governance: adverse selection, agency, asymmetric information, (executive) compensation, corporate governance, Fisher separation, moral hazard, principal-agent.

In managerial economics, the study of moral hazard is ethically neutral; there is no (im)morality in

moral hazard. Indeed, students would be hard-pressed to explain the use of the term “moral” given

the treatment of moral hazard in all the texts surveyed.6 Characteristically, one text asserts, “the

term moral hazard contains no connotation of dishonesty; it simply refers to the typical reduction in

the economic incentive to avoid undesirable effects.” From an ethical perspective, perhaps

economists should drop the term moral hazard, using instead “hidden action.”

By contrast, from an accountant’s perspective the close connection between ethics and

economics is no more evident than in agency theory (Noreen 1988: 359). Arrow (1968: 538) makes

a similar argument, “One of the characteristics of a successful economic system is that the relations

of trust and confidence between principal and agent are sufficiently strong so that the agent will not

cheat even though it may be ‘rational economic behavior’ to do so…Nonmarket controls, whether

internalized as moral principles or externally imposed, are to some extent necessary for efficiency.”

Noe and Rebello (1994) provide a theoretical foundation for this perspective.7 By their

5 Hattwick (1986) discusses the behavior of marginal revenue across the range of ethical behavior. 6 Bernstein (1996: 13) reports that dice games brought back to Europe via the Crusades were generally referred to as “hazard,” from al zahr, the Arabic word for dice. Further, in ancient Egypt compulsive gamblers were punished by being forced to hone stones for the pyramids. In an alternative context, an ethical imperative implicit in any insurance contract is that the insured will not alter his/her behavior when the insurer agrees to bear part of the risk. 7 See also Koford and Penno (1992).

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definition, an ethical manager is one who always exerts high effort, and undertakes projects even

if they are marginally profitable (only through high effort). By contrast, unethical managers may

take on projects that are only profitable through low effort. Further, the proportion of ethical

behavior is unknown to potential investors, but is endogenously determined by the past losses

that occur from following ethical codes. Among many important propositions, they provide

conditions under which a nonzero level of ethics is stable for the economy (proposition 5) as well

as those in which cyclical swings of ethics occur (proposition 6); i.e., ethics bubbles. Whether

the proportion of ethical workers is stable or not depends upon the initial distribution of ethical

and non-ethical workers. Noe and Rebello argue that parenting and education determine the

initial distribution of ethical agents. Table 1 sheds doubt on whether such education occurs in

the managerial economics curriculum.

Brickely et al (p.619) posit ethics as a (partial) solution to governance problems, stating

that higher ethical standards among agents, whether corporate employees or participants in

market exchanges, would lead (over time) to a reduction in the level of expected opportunistic

behavior and thereby a reduction in contracting costs. Several texts have significant coverage of

issues pertaining to corporate governance, albeit without specific reference to ethics. For

example, Hirschey (p.577) discusses how employee stock options can create “golden handcuffs”

that lead senior executives to act in the best long-term interests of shareholders because of

aligned self- interest. A tradeoff arises; however, because stock option plans can dramatically

understate the total amount of employee compensation. The Sarbanes-Oxeley Act (2002) was

created in recognition of this. Yet as Alan Greenspan has been said to remark, “I don’t think that

you can legislate morality,” (Truett and Truett, p.302).

Solutions offered to solve principal-agent problems include incentive contracts, reputation,

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the threat of takeover, revenue sharing, piece rates, monitoring, etc., but rarely an appeal to the

ethics of shirking or taking excess perquisites. By contrast, Arthur Andersen attributed the auditing

partnership’s success to a corporate culture that led to its “think straight, talk straight” motto. The

violation of this motto in its dealings with Enron contributed to its downfall.

3.3.1 Governance Teaching Moment

Several texts use stylized models of the principal-agent relationship as a natural context

for introducing and motivating mixed strategies (Baye, Brickley et al). In such models the

agent’s action is not completely hidden, but it is costly for the principle to observe the agent’s

action and these costs endogenously determine the information structure that is assumed to hold

when examining the impact of alternative compensation schemes. An example is given in box 1.

The principal can monitor (M) at opportunity cost µ > 0, or not monitor (N). Workers can work

(W), with the cost of effort being e > 0, or shirk (S). So long as they are not caught shirking,

workers earn efficiency wage we. If a worker is caught shirking – the (M,S) strategy

combination – he/she is fired and receives outside wage wo < we.

Box 1: Stylized Principal-Agent Game

↓Principal/Agent→ Work (W) Shirk (S) Monitor (M) -µ, we - e -µ, wo

Not (N) 0, we - e -we, we This game has no pure strategy Nash equilibrium if the cost of monitoring is less than the

efficiency wage, µ < we, and the efficiency wage less the cost of effort exceeds the outside wage,

we – e > wo. The game has a mixed strategy equilibrium, where σS = µ/we is the likelihood of

shirking, and σM = e/(we-wo) is that of monitoring. It is intuitive that the manager is not

constantly monitoring because he/she has other duties to perform for the firm, and these define

the opportunity cost of monitoring. This endogenously produces an imperfect information

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structure in which some shirking goes undetected, as is expected when the observation of effort

is costly. Moreover, the amount of monitoring is inversely related to the degree in which the

efficiency wage exceeds workers’ outside option.

A novel interpretation of σS arises from Nash’s (1950) mass action explanation of his

equilibrium concept. Here, fraction 1-σS is the proportion of workers who never shirk; i.e., ethical

workers. The result is akin to Noe and Rebello’s derivation of a bifurcated population of ethical

and unethical agents, the (evolutionary) stability of which can be investigated via simulation.

I conclude briefly with whistle blowing, the unauthorized release of a firm’s proprietary

information for the purpose of disclosing a firm’s illegal behavior, mismanagement,

endangerment of the public interest, etc. Most texts lack the logical prerequisite – a discussion

of ethics – for examining effective standards of protection for whistle blowers.8 Yet whistle

blowing is an important aspect of corporate America, as is evidenced by Time Magazine naming

Coleen Rowley, Cynthia Cooper and Sherron Watkins as their 2002 ‘Persons of the Year.’

These three were the whistle blowers for FBI intelligence failures and corporate corruption at

Enron and WorldCom, respectively.

3.4 Firm Objectives: profit maximization, revenue maximization, shareholder (stockholder) responsibility, shareholder (stockholder) wealth maximization.

The profit maximization objective of the firm is taken to be self-evident. Only 58% of texts

contain a justification of the profit maximization assumption, typically focusing on how the

dynamic version is consistent with the mantra of financial economics: shareholder wealth

maximization. Yet unethical firms are unlikely to survive long enough to maximize shareholder

8 In the US, public employees have rights under whistle blower protection acts. In the private sector, whistle-blowing employees are usually fired, and those who are retained generally experience retaliation in some form. For those who are fired, their ability to find alternative employment depends on public opinion and, paradoxically, may be hindered by the decreased reputation of their past employer.

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wealth over the long run. 9 Economic Darwinism is another popular justification of profit

maximization. The idea is that competition has a “survival of the fittest” flavor that makes it akin

to an evolutionary process. If profit is a measure of a firm’s evolutionary fitness, the process of

natural selection works against firms that do not profit maximize. Yet economic Darwinism does

not give a behavioral prescription for how firms are to go about creating their profits.10 In

particular, there is no reason to believe that managers with veracity and integrity are at a

competitive disadvantage.

3.4.1 Firm Objectives Teaching Moment

The teaching moment describing the four potential objective functions for the firm in

subsection 3.2.1 applies here as well. In addition, ethics are part of the opportunity costs that

differentiate economic profit from accounting profit. From day one, managerial economics

students are familiar with this difference because it shifts the focus from one on costs themselves

to the way in which they are incurred. For example, it is entirely possible for two divisions within

a firm to appear equally profitable on the accountant’s balance sheet, and yet for one to be making

an economic profit and the other a loss due to differences in capital structure and returns on capital

(Ehrbar 1998). The key question is how to valuate ethical opportunity costs. Indeed, in Risk,

Uncertainty and Profit, Frank Knight (1921) recognized that the economic definition of profit

“cannot be carried out to its theoretical completeness.”11 This is the challenge of effective

management. If management is up to the task, Primeaux and Stieber (1995) contend that the

ethical mandate for a company can then be clearly defined as profit maximization through 9 It is interesting to note that longstanding organizations involved in illegal enterprise often have their own set of ethics that are at odds with society, for example, the mafia. 10 Further, profit maximization is not a fait accompli of economic Darwinism because natural selection is not equivalent to survival of the fittest. Shubik’s (1954) analysis of a 3-player duel – where the worst marksman is the most likely to survive– illustrates the difference. Further, Shaffer (1989) has shown that once competition is framed in formal evolutionary terms, natural selection need not work against firms who forgo profit maximization to revenue maximize. 11 Quote cited in Bartley (2003). Moreover, Knight (1935) was concerned about the interplay between the market process and the ethics of business leaders.

16

efficiencies. Unethical decisions represent a misappropriation of scarce resources.

Consider the sale of university-licensed apparel, the revenue of which is often divided

between a university’s athletic department and academic scholarships for non-athletes. Is

certification that the apparel was not produced under “sweat shop” conditions of value to students,

alumni, faculty, administrators, and fans? Should the university select a monitoring agency that

insists producers pay a “living wage?” How many scholarships is it worth? 12

3.5 Competition Barriers: advertising, antitrust, barriers to entry/exit, block pricing, bundling, competition law/policy, entry deterrence, limit pricing, penetration pricing, predatory pricing, price discrimination, price skimming, quantity discount, regulation, rent seeking (lobbying), resale price maintenance, restrictive trade.

The activities in this subsection refer to barriers to entry arising from firm conduct, rather than

those imposed by the government or inherent in the structure of the market. For example, while

the tradeoff between the sunk costs and demand-stimulating aspects of advertising appears in

virtually every text, discussion of the legal and ethical implications of advertising is sparse. Yet

there are several ethical issues involved in advertising. First, in markets where advertising

competition supplants price competition, an ethical agreement has implicitly taken place between

firms that (non-negative) advertising competition is “civilized” – it rewards creativity – whereas

price competition requires little managerial skill and dramatically erodes profits. This is why

firms do not collude themselves out of the “advertisers’ dilemma” when such activity is

seemingly legal (Douglas, p.540). Second, the Supreme Court has ruled that advertising is not

protected as free speech as guaranteed under the First Amendment. Clearly, there is an ethical

difference between the two. Third, a number of texts assert that false advertising is irrational

because advertising is a sunk cost that will not be recouped once consumers discover claims are

untrue. Yet The Landhan Act (1942) allows consumers, competitors, and the FTC to file civil 12 Certification may increase revenue; however, campus protests about licensed material are usually framed in ethical terms, rather than their potential to shift the demand curve.

17

suits against false advertising. Successful suits result in treble damages. The same managerial

texts provide no explanation for why the Landham Act exists.

Turning to the issue of competition barriers, it is useful to move from a quantitative

measure of the intensity of concern to a qualitative one. This is because all texts cover

competitive tactics; hence, I distinguish between legal and ethical coverage in columns 4 and 5 of

table 1. Moreover, many texts cover the legal aspects of pricing in separate chapters on

regulation, antitrust, or competition policy. A simple test can be used to verify whether separate

coverage achieves its purpose. Place your students in a context where they are a supplier of

canned goods to a national supermarket chain and a small mom-and-pop grocery store. The

supplier has constant marginal costs, but the national chain can buy in significantly higher

quantities. What price should the profit-maximizing supplier charge each retailer? If the technical

aspects of price discrimination predominate, you are likely to get an answer that conforms to

second-degree price discrimination. Yet the Robinson-Patman Act (1936) was created to

strengthen section II of the Clayton Act (1914) to prohibit price discrimination between firms

when it limits competition in the buyers’ market. It was specifically designed for the grocery store

situation to prevent suppliers from endowing a firm with a cost advantage over its rivals.

How confident are you that your students will provide an answer recognizing the legality of

firm-to-firm price discrimination, rather than blindly calculating the answer to what is otherwise a

straightforward pricing problem? This is why it is worthwhile to place a judicious statement

clarifying that firm-to-firm price discrimination is illegal unless it is based on cost or industry

differences within a text’s coverage of price discrimination. Such statements appear in context in

Brickley et al (p.183), Samuelson & Marks (p.107), Shim & Siegel (pp.325-6), and Truett & Truett

(p.471). More obvious to students – yet rarely covered in texts – is the idea that price

18

discrimination based on race and gender is illegal. Clearly, the rationale is ethical here. Texts are

quick to identify (legal) discriminating variables for price discrimination but do not forewarn

students about illegal ones. Finally, students will quickly see that colleges and universities can

employ financial aid to price discriminate and fix prices. Indeed, in 1991 the Justice Department

successfully convinced Ivy League Schools and members of the Great Lakes Colleges Association

to stop the appearance of price fixing through the use of a common financial aid formula.

3.5.1 Competition Barriers Teaching Moments

The ethics of price discrimination create tradeoffs for firms that are largely ignored in

textbooks. For example, consumers often react negatively when it is discovered that mail order

catalogs list different prices according to zip code, or that web sites charge regular visitors more

for merchandise than they do newcomers (Nellis and Parker, p.254). The technical ability to

discriminate across consumers/markets does not imply that it is in the long-term interest of the

firm to do so. In the United States there is the perception that high pharmaceutical drug prices are

used to subsidize lower prices in other countries. Further, while it may be ethically defensible to

charge higher prices for AIDS-treatment drugs in the US and lower prices in Africa, the same

cannot generally be said for the difference between pharmaceutical prices in the US and Canada.

Congress has responded by proposing bills that would allow pharmaceutical arbitrage between the

US and select countries. I have used outrage over wage discrimination in the workplace to recruit

female majors by pointing out that female economics majors earn a larger salary– as a percentage

of their male counterparts (Hecker 1998) – than do majors in other business fields.

The US’s primary law regulating tying is section 1 of the Clayton Act (1914), which

forbids tying to lessen competition or vertically extend monopoly power. Tying is not per se

illegal, but is instead subject to judgment related to the market share that the firm is capable of

19

leveraging to enforce a tying requirement. The argument that a firm can use tying to expand its

monopoly power is a legal quagmire, as the Justice Department’s lawsuit against Microsoft’s

marketing of its Explorer web browser illustrates. Again, the Clayton aspects of tying are rarely

mentioned within context. A notable exception is Besanko and Braeutigam (p.539), who discuss

the legality IBM’s tying of punch cards to its office machines, and McDonald’s sale of cups and

napkins to its franchisees alongside its presentation on tying.

Most textbook discussions of tying and its derivatives (bundling, metering, block pricing,

etc.) treat them as a form of price discrimination that represents a quantity discount. Quantity

discounts are widely accepted if based on market differences; but kickbacks to select buyers are

viewed as unethical, and not just by those who do not receive the kickbacks (Moor 1987). Consider

also the emerging obesity lawsuits against fast food companies. The economics of the ethics is that

Super Sizing© is a form of penetration pricing, and consumers must eat the entire meal in order to

accrue the consumer’s surplus that would justify their purchase over a lower-priced lower-calorie

alternative. The counterargument is this pricing strategy is a form of second-degree price

discrimination where consumers voluntarily self-select into meals. This is the logic behind the

Personal Responsibility in Food Consumption Act currently before the House Judiciary Committee.

An opportunity for an ethical discussion of bundling is the on- line swapping of music files.

Currently, the predominant pricing model in the music industry is a CD or cassette, a practice that

bundles all the songs that an artist has currently released together. File sharing websites such as

Napster and it progeny represent an alternative to bundling. The music industry views such

unbundling as a violation of copyright law, and it remains to be seen if new pric ing models such as

Apple’s iTunes© website will resolve the ethical difference between music firms and their customers.

I finish this section with barrier-creating activities that are not profitable in themselves, but

20

are designed to reduce competition: predatory pricing, limit pricing, and rent seeking. The

managerial economics of such issues is typically positive – directed at the question of whether such

strategies can credibly deter entry. A largely unspoken ethical rationale for examining these issues

is that barriers to entry that artificially prevent other firms from competing in a market are

inherently viewed as unfair (Mathis and Koscianski, p.411). Further, rent seeking has a dark side

involving bribing legislators or bureaucrats, spying on competitors, or using the legal system to

harass competitors or forestall legislation (Petersen and Lewis, p.332).

3.6 Collusion: antitrust, auction rings, cartels, cooperation, legal(ity), price fixing, regulation, restrictive trade, tacit collusion.

The treatment of collusion in managerial economics offers an interesting dichotomy. On one

hand, there may be less need for a discussion of ethics because price fixing is illegal per se –

there is no need to demonstrate unreasonableness because it is presumed to be unreasonable. On

the other hand, statements regarding the illegality of collusion are rarely given when tacit

collusion is covered in managerial texts. For the most part, the illegality of cartels is covered

elsewhere, usually in a chapter on regulation or antitrust that focuses on explicit collusion. Keat

and Young, whose chapter on special pricing practices includes discussion of price fixing by

General Electric and Westinghouse, Sotheby’s and Christie’s, and Archer Daniels Midland, give

the most integrated coverage. A few other texts lead off their chapters on the game theoretics of

tacit collusion with statements such as, “cartels are illegal.”

3.6.1 Collusion Teaching Moment

The positive justification of tacit collusion in a Prisoner’s Dilemma cum cartel is that it

achieves a Pareto improvement for firms (an example of the Prisoner’s Dilemma is given in box

3). Completely lost in the discussion are the consumer benefits of competition among firms. This

contrasts with Tucker’s (1950) original presentation of the Prisoner’s Dilemma, where the

21

state’s/District Attorney’s preferences are listed, even though the DA exercises no choice.

Consumers have a similarly passive role in most models of cartel behavior, yet this does not mean

that their welfare should be ignored. Indeed, from a theoretical perspective the goal of antitrust

policy includes (i) increasing a firm’s discount factor so that it does not pass the threshold required

to support collusion, or (ii) regulating the market so that the playing field is more akin to a single-

shot Prisoner’s Dilemma, rather than an iterated one.

3.7 The Market System (and alternatives): auctions, bargaining, J.K. Gailbraith, invisible hand, Adam Smith.

Few managerial texts spend the time to justify the price system for allocating resources. Perhaps

this is due to the collapse of any notable alternative, a role the Soviet Union played for some 50

years. Yet the right to step to the head of the line at a bank or sporting event is rarely auctioned off.

Instead, a first-come, first-served rule prevails. One observes a fair amount of resentment at

security checkpoints in airports when first class ticket holders are allowed to share the “crew line”

and bypass a longer wait with other passengers. Students readily object to the idea that desirable

dorm rooms, tickets for on-campus athletic and concert events, and priority for class registration

could to be sold to the highest bidder, rather than allocated according to some uncorrelated

asymmetry such as class rank. Clearly, there is an ethic at work that establishes the social norm for

allocating some goods and property rights via a price system, and others under alternative means.

This issue comes to the forefront when considering the ethics of a market for human organs.

References to Adam Smith within managerial texts are rarely used as a starting point for

the discussion the ethics of the marketplace. Instead, they are limited to vignettes from The

Wealth of Nations touting the benefits of self- interest (it is not out of the benevolence of the

butcher, the brewer, or the baker that we expect our dinner…), specialization (the pin factory),

and market efficiency (the ‘invisible hand’). By contrast, Bowie (1988) addresses the question of

22

when voluntary transactions in competitive markets are fair. The ethical concepts he identifies

include (i) participants act in good faith, (ii) transactions are not coercive, (iii) no side can be

exploited due to inequality of knowledge or economic power, and (iv) no discrimination among

equals.13 By examining legal rulings and the judgments of juries, Bowie finds that appealing to

the tenet of fairness – as embodied by these concepts – is the standard technique used by the courts

and juries to resolve hard cases involving laws that regulate market transactions. Moreover, these

ethical concepts cannot be codified in themselves. This is another rationale for why firms and

managers cannot use the question, “Is it legal?” to identify whether a practice is moral or not.

Consider the market for portable generators for residential use. Does the fair functioning of

the market imply that an increase in demand, ceteris paribus, leads to an increase in price? If the

increase in demand is due to the increase in on- line workers at home in need of an uninterrupted

power supply (e.g., mortgage brokers and day traders), few will argue against the resultant increase

in equilibrium price. What if the increase in demand is due to a local power outage during adverse

weather conditions when consumers need temporary power for purposes of survival? Raising

prices due to this type of increase in demand is generally viewed as coercive. As Hirshleifer (1987)

discusses, a market ethic often exists during disasters where prices that might have been expected to

rise remain unchanged or even fall.

In markets with inequality of knowledge between buyers and seller, such as the professions,

Arrow (1974) points out that codes of ethics and standards of conduct often replace overt legal

regulation. In a series of experiments, Pitchik and Schotter (1994) examine an experts market with

information asymmetries that allow for unscrupulous behavior. They find that subjects/experts

stuck to an ethic of honesty for themselves and adhered to it, regardless of whether an expert was

13 This list is just as interesting for what it excludes as criteria for judging the fairness of marketplace, for example, the inequality that is produced by paying workers according to marginal productivity.

23

competent or incompetent.14 Further, a policy of licensing experts, thereby reducing the fraction of

incompetent experts, increased the level of honesty in the market. Intuitively, it became easier to

distinguish unscrupulous behavior from honest incompetence. Paradoxically, price controls –

administratively reducing the price of highest-cost services – decreased the level of honesty. Price

controls have a general equilibrium effect of increasing consumers’ willingness to accept a high

price diagnosis, rather than search for alternative opinions. Unscrupulous experts took advantage of

this decreased willingness to search. Pitchik and Schotter conclude that in markets with asymmetric

information it is naïve to endorse either price controls or free markets for securing fairness.

I conclude this section with an example that illustrates the endogeneity of “ethical”

behavior in markets. Freeman and Gilbert (1988: 91) state that a basic axiom of corporate

strategy is, “putting oneself in the place of others and attempting to see the situation from their

perspective,” and label it as the 3rd axiom of corporate strategy. The axiom is related to Rawls’

(1971) veil of ignorance and the philosophical principal of willingness to universalize. Freeman

and Gilbert argue that a problem arises because observation of ethical behavior is not equivalent

to a company having ethical preferences. Consequently, they propose that game theory can be

productively used to disconnect the notion of ethics – in the form of preferences – from corporate

strategy conclusions based on observed actions.

For example, suppose that a tentative finding has come out that might precipitate a recall

of a company’s product. If the company recalls their product, is this evidence of a “socially

responsive” corporate strategy? The 3rd axiom of corporate strategy would suggest that it is. Yet

companies rarely make such decisions without considering the reactions of others: the

government, consumers, etc. In figure 1 such a company (C) is faced with the prospect of

14 This ethic did vary with parameter changes and policy interventions introduced into the model, indicating that it was unlikely that their results merely identified honesty norms that the subjects brought from their daily lives into the laboratory.

Figure 1: Social Company, ‘Fight if Need’ Be Authority

C

A A

3 2

2 1

1 3

4 4

R K

B N N B

Figure 2: Π -Max Company, ‘Fight if Need Be’ Authority

C

A A

2 2

4 1

1 3

3 4

R K

B N N B

Figure 3: Π -max Company, ‘Lassez-Faire’ Authority

C

A A

2 2

4 3

1 1

3 4

R K

B N N B

24

recalling its product (R) or keeping it on the market (K). Further, a government regulatory

agency (A), can either ban (B) the product or not (N). Freeman and Gilbert suggest that a

socially concerted company would have the ordinal preferences given in figure 1, with the best

possible outcome being a payoff of 4, the top payoff listed for the (R,N) path of the game. The

company voluntarily recalls the product without any prompting from the agency. The worst

possible payoff for a socially concerted company is the 1 given in the (K,B) path, where the

company is forced to take the product off the market by the agency. The preferences of the

agency are described as “fight if need be,” given by the bottom payoffs in figure 1.

The subgame perfect Nash equilibrium is (R,NB) and the company is observed to be

voluntarily removing its product from the market. The company is classified as socially

responsive, consistent with its preferences. But what if instead the company has “profit

maximizing” preferences, as depicted in figure 2? If it keeps its product on the market and the

agency takes no action, the likelihood of successful civil action against the company is

minimized and it retains its market share as well, yielding a payoff of 4 on the (K,N) path. The

worst possible outcome is to keep the product on the market when it is banned, the 1 on the

(K,B) path. Recalling the product when it is not banned is likely to lessen the severity of a civil

penalty (a payoff of 3) as compared to a recall when the product is banned (a payoff of 2). Yet

the subgame perfect equilibrium again predicts that the company recalls its product. The

observational conclusion is that the company is socially responsive, when in fact its preferences

are not those of a socially responsive company!

The preferences of the agency drive the “ethics” of the company. If the agency’s

preferences are changed to “lassez-faire,” figure 3 is the corresponding game. In equilibrium the

profit-maximizing company keeps the product on the market. The classification of the company

25

according to the 3rd axiom has changed even though the preferences of the company are the same as

those of figure 2! What, then, constitutes the observation of an ethical firm in such circumstances?

3.8 Welfare Criteria: cooperation, distribution, equity, fairness, golden rule, justice, Pareto efficiency/optimality, John Rawls, social welfare function, utilitarian, welfare economics.

I finish this section with the set of topics that are most closely related to ethics and yet

quintessentially demonstrate the dearth of ethical discussion in managerial texts. Nearly every

welfare criterion has an underlying ethical rationale, if not origin. Pareto efficiency is presented in

every managerial text, yet the ethical assumptions required to endow Pareto efficiency as the

primary welfare criterion in economics are never discussed.15 Indeed, it is often regarded that

efficiency is no longer tied to ethics. For example, a Pareto improvement usually affects the

distribution of income, yet little consideration is given to the latter if the former is possible, nor to

the ethics of the means for reaching the improvement. An exception is Brickely et al. (p.619),16

who qualify punishment-based approaches for implementing Pareto improvements in the business

world with the following quote from the Wall Street Journal (Aaron 1994): “[W]e learned there are

two ways to go: an eye for an eye, or do unto others as you would have them do unto you. In

business, the latter principle is far more common, simply because it makes things work better.”

Further, the cooperative benchmark (or explicit collusive agreement) in the analyses of

Cournot duopoly and the Prisoner’s Dilemma is almost exclusively taken to be the joint strategy

that maximizes the sum of players’ payoffs. This solution is on the contract curve; hence, it is

Pareto efficient. From the perspective of moral philosophy, maximizing the sum of payoffs is

known as the utilitarian solution. A utilitarian seeks to maximize the common good, and

summing up individual payoffs measures how much common good is generated. The wholesale

15 See Sen (1987), chapter 2 and Creedy (1994). 16 See also FitzRoy et al p.303 and 307 and McGuigan et al p.760.

26

omission of other cooperative solutions within managerial texts is virtually an unacknowledged

endorsement of utilitarianism. “It is arguable that the utilitarian criterion, and also that of Pareto

efficiency, have appeal particularly because they have not especially taxed the ethical imagination

of the conventional economist” (Sen 1987: 50). It is not surprising, then, to find the utilitarian

sum implicit in several economic definitions of business ethics (Prasad et al 1993: 70). Friedman

(1970) effectively defines a utilitarian objective function for welfare within the firm. It includes

stockholders, customers, and employees. He uses it to argue against the social responsibility of

the firm, thereby identifying those whose utility is excluded from the sum.

3.8.1 Welfare Teaching Moment

Pareto efficiency is generally presented without argument. Alternatives include the golden

rule and Rawls’ (1971) maximin criterion. Either can be used to show how social dilemmas can be

resolved without resorting to coercion. Consider the Chicken game given in box 2. In managerial

texts, Chicken is often motivated as a canonical model of bargaining, with one player acquiescing

(A) to the insistence of the other (I) so that the gains from trade can be efficiently distributed. The

pure strategy Nash equilibria are (I,A) and (A,I), with the determination of which player gets the

lion’s share left to institutional details, or making the game dynamic (e.g., the War of Attrition).

Yet because the golden rule appears in some form in every major religion, students understand it at

least as well as they do Nash equilibrium. For this reason it is hard for the economically uninitiated

to believe that the gains from trade must be split asymmetrically among players with equal rights.

Indeed, (A,A) will result if behavior conforms to the ethic of the golden rule or Rawls’ maximin

criterion. No coercion is required, nor is there the risk of the (I,I) outcome occurring, as would be

the case for the mixed strategy Nash equilibrium that ‘hits’ (A,A).

The golden rule and maximin ethics do not always coincide, as is illustrated by the

Box 2: Chicken

I A Insist

(I) 0, 0 75, 25 Acquiesce

(A) 25, 75 50, 50

Box 3: Prisoner’s Dilemma

D C Defect

(D) 25, 25 75, 0 Cooperate

(C) 0, 75 50, 50

Box 4: Hero

A B A 25, 25 75, 50 B 50, 75 0, 0

27

Prisoner’s Dilemma in box 3. Here, each player would prefer that the other play C. Mutual

cooperation results from the golden rule. By contrast, (D,D) results from maximin behavior.

Finally, the ‘hero’ game in box 4 neatly illustrates that the golden rule cannot be a universally

desired ethic; it leads to the (B,B) outcome.

4. Conclusion

Business ethics are in the public eye more than ever. Yet this awareness does not appear to extend

to managerial economics. I have presented a content analysis of 21 managerial economics texts

currently in print. There is much to be learned from these texts; indeed, the diversity of emphasis

is astounding. By choosing among them one could not only teach a general course on managerial

economics, but others focusing on myriad issues of importance to managers, with one notable

exception – ethics in economic decision making. Further, theoretical analyses of the importance

of business ethics to mitigate phenomena such as adverse selection and moral hazard rely on initial

conditions that assume agents receive ethical training as part of their education. In its current

state, managerial economics fails the test. Substantive discussion of ethics for economic decision-

making is conspicuous by its absence. As such, I have presented numerous examples of how

ethics can be incorporated into the economic theory of the firm.

Many Nobel laureates in economics recognize the importance of ethics for the long-

term survival of the firm. It is therefore a sociological question as to why there is a dearth of

published material on ethical decision-making in economics.17 Friedman’s (1970) article on

the social responsibility of the firm clearly states that the ethical environment matters for firm

behavior. Havrilesky (1993) contends that the neglect of ethics is a result of technical

17 See, for example, Hoass and Wilcox (1995) and Northrup (2000).

28

emphasis in economics.18 Sen (1987) asserts that ignoring ethics has seriously limited the

scope of predictive economics. Further, ethics-related issues such as fairness, reciprocity,

commitment, social capital, and social networks are at the frontier of theoretical and

experimental economics. For ethics in particular; however, highbrow advances are of little

use if they are not integrated into the curriculum.

18 Similarly, Primeaux and Stieber (1999) opine that it is due to a focus on mathematical representations rather than the behavior they symbolize.

29

Appendix: Textbooks

Baye, Michael R. (2003). Managerial Economics and Business Strategy, Fourth Edition, Boston: McGraw-Hill.

Besanko, David and Ronald R. Braetigam (2002). Microeconomics. An Integrated Approach, New York: Wiley.

Blackwell Publishers (1997). Encyclopedia of Managerial Economics, Robert McAuliffe (ed.), Malden, MA: Blackwell.

Boyes, William (2004). The New Managerial Economics, Boston: Houghton Mifflin. Brickley, James A., Clifford W. Smith Jr., and Jerold L. Zimmerman (2004). Managerial

Economics and Organizational Architecture, Third Edition, Boston: Irwin. Douglas, Evan J. (1992). Managerial Economics. Analysis & Strategy, 4th Edition, Upper Saddle

River, NJ: Prentice Hall. Fisher, Timothy C.G. and Robert Waschik (2002). Managerial Economics. A Game Theoretic

Approach, London: Routledge. FitzRoy, Felix R., Zoltan J. Acs and Daniel Gerlowski (1998). Management and Economics of

Organization, Essex: Financial Times Prentice Hall. Hirschey, Mark (2003). Managerial Economics, Tenth Edition, Mason, OH: Thompson South-

Western. Keat, Paul G. and Philip K.Y. Young (2003). Managerial Economics. Economic Tools for

Today’s Decision Makers, Fourth Edition, Upper Saddle River, NJ: Prentice Hall. Mansfield, Edwin, W. Bruce Allen, Neil A. Doherty and Keith Weigelt (2002). Managerial

Economics. Theory, Applications, and Cases, Fifth Edition, New York: Norton. Mathis, Stephen A. and Janet Koscianski (2002). Microeconomic Theory. An Integrated

Approach, Upper Saddle River, NJ: Pearson Education. Maurice, S. Charles and Christopher R. Thomas (2002). Managerial Economics, Seventh

Edition, Boston: McGraw-Hill Irwin. McGuigan, James R., R. Charles Moyers and Frederick H. deB. Harris (2002). Managerial

Economics. Applications, Strategy, and Tactics, Ninth Edition, Cincinnati: Thompson. Nellis, Joseph and David Parker (2002). Financial Times Principles of Business Economics,

Harlow, England: Prentice Hall. Petersen, H. Craig and W. Cris Lewis (1999). Managerial Economics, Fourth Edition, Upper

Saddle River, NJ: Prentice Hall. Png, Ivan (2002). Managerial Economics, Second Edition, Cornwall: Blackwell. Salvatore, Dominick (2004). Managerial Economics in a Global Economy, Fifth Edition, Mason,

OH: Thompson South-Western. Samuelson, William F. and Stephen G. Marks (2003). Managerial Economics, Fourth Edition,

New York: Wiley. Shim, Jae K. and Joel G. Siegel (1998). Barron’s Managerial Economics, Hauppauge, NY:

Barrons. Truett, Lila J. and Dale B. Truett (2004). Managerial Economics. Analysis, Problems, Cases,

Eighth Edition, Crawfordsville: Wiley.

30

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