79. Capitalism and Freedom, Part 2

Note: This post is the seventy-ninth in a series about government and commercial ethics. Click here for the full listing of the series. The first post in the series has more detail on the book 'Systems of Survival' by Jane Jacobs which inspired this series.

This week's post is a follow-up on last week's post on the book 'Capitalism and Freedom' by Milton Friedman.

Last week I promised to explore in more detail an example of where Milton Friedman got carried away with his 'market good, government bad' mindset. The specific topic I want to cover is Friedman's comment that,

"The view has been gaining widespread acceptance that corporate officials and labor leaders have a 'social responsibility' that goes beyond serving the interests of their stockholders or their members. This view shows a fundamental misconception of the character and nature of a free economy. In such an economy, there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud.¹"

As we'll see, the trouble with this statement is that while it is true that businesses have an obligation to pursue profits, Friedman unnecessarily constrains their other moral obligations, ruling out things like taking action to fight pollution as being a violation of a company's duty to pursue profits first.

This will be a lazy post for me, since I'm going to let Joseph Heath do most of the talking, via his essay, "A Market Failures Approach to Business Ethics" Really, you'd be better off just reading Heath's whole essay - it's easy to follow and not particularly long, but I'll summarize the main points here that are relevant to our Systems of Survival theme.

Heath first argues that the obligation of the business to earn profits is not a simple reflection of self-interest on the part of company shareholders but rather is a moral duty. The profits earned are a reflection of the ability of the shareholders ability to deploy resources where they are wanted/needed by the population - so the greater the profit, the greater the gain to society, and hence the duty to earn profits.

Naturally, many people will find this a little hard to swallow. Heath reasons that one reason people find this difficult to accept is that, unlike say a doctor's obligation to their patients, the obligation of a a manager to make profits is more like the indirect role played by trial lawyers in which an action which in and of itself has little moral justification (making money for shareholders / defending accused criminals) has value because of the role it plays within a system with various parts.

Heath:

"We understand implicitly that the professional conduct of doctors is to be entirely governed by their obligations to their patients, and thus that they are not permitted to let considerations of self-interest intrude. Profit-maximization has precisely the same status for managers.

...

Health is widely regarded as a good thing, and thus the doctor’s actions serve to promote a state of affairs that is morally desirable. This makes the doctor’s actions directly justifiable, even intrinsically altruistic. Things are more complicated in the case of business. It is not clear that profits are intrinsically good. Furthermore, when a manager makes a decision that disadvantages workers in order to benefit owners, the profit maximization imperative generates a distributive transfer that is by no means morally sanctioned. In fact, under the typical set of circumstances, the transfer will be regressive, and thus problematic from the moral point of view.

The asymmetry arises from the fact that profit maximization is only indirectly justified. It is useful to note that this problem is one that business ethics shares with legal ethics. The adversarial trial system imposes upon lawyers an obligation to do whatever is in their power to defend or advance the interests of their client, even when these interests are highly refractory to the concerns of justice. Thus the professional obligations of lawyers often conflict with the imperatives of everyday morality. What justifies their behaviour is the fact that they operate in the context of an institution with differentiated roles. The desirable outcome is a product of the interaction between individuals acting in these roles, none of whom are actually seeking that outcome. Justice is best served when there is both vigorous prosecution and vigorous defence.

Thus the effective trial lawyer 'promotes an end which is no part of his intention.'"

Next, Heath explains that the moral duty to seek profit flows from the first theorem of welfare economics which states that economic (pareto) efficiency is maximized when a bunch of conditions known collectively as 'perfect competition' are met, with one of the conditions being a number of firms competing to make the most profits.

Heath:

"Thus the primary reason for introducing the profit motive into the economy is to secure the operation of the price mechanism. The price mechanism is in turn valued for its efficiency effects. It allows us to minimize waste. The formal proof of this is often referred to as 'the first fundamental theory of welfare economics” (hereafter FFT), or else, in a nod to Adam Smith, the 'invisible hand theorem.' The central conclusion is that the outcome of a perfectly competitive market economy with be Pareto optimal – which means that it will not be possible to improve any one person’s condition without worsening someone else's."

Where things get tricky is that there are a number of other conditions for perfect competition (recall our earlier posts on Walter Schultz's 'Moral Conditions of Economic Efficiency')

The trouble is that competition only leads to efficiency if a number of conditions are met, the most commonly recognizes ones being the avoidance of force and fraud. As Heath notes, Friedman implicitly recognizes these moral obligations when he insists that the responsibility of the business is to, "to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud."

Where Friedman gets into trouble is in ignoring other possible violations of economic efficiency, most notably, the loss of efficiency caused by externalities that aren't priced into a business' products. For example, if company A drives company B out of business by offering lower prices, not because company A was better managed than company B but because company A lowered costs by dumping toxic chemicals into the water supply instead of paying to treat them like company B did, then this is not a gain in efficiency for society.

Heath:

"Despite some confusion, it is clear that Friedman's managers have genuine ethical responsibility to shareholders, and that this responsibility is derived from the FFT. The problem is that Friedman arbitrarily limits the set of obligations to those that support only some of the many Pareto conditions.

For example, Friedman argues that pollution reduction is one of the illegitimate responsibilities pressed upon managers in the name of 'social responsibility.' But pollution is a negative externality – a cost associated with some economic activity that is transferred to a third party without compensation. These externalities exist because the set of markets is incomplete. We cannot exercise property rights over the air that we breathe, for example. As a result, while we can charge people for dumping noxious substances on land that we own, we cannot do the same when they dump it in the air. For this reason, one of the Pareto conditions specifies that there must be no externalities. Any corporation that pollutes is essentially profiting from a market imperfection. This means that there is no difference, from the moral point of view, between deception and pollution – both represent impermissible profit-maximization strategies.

Friedman's decision to prohibit deception, while giving the wink to environmental degradation, is arbitrary and unmotivated."

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¹ This quote is from Capitalism and Freedom, page 133, but you can also refer to Friedman's article, "The Social Responsibility of Business is to Increase its Profits," which covers the topic of this post specifically.

51. Types of Cooperation

Note: This post is the fifty-first in a series. Click here for the full listing of the series. The first post in the series has more detail on the book 'Systems of Survival' by Jane Jacobs.


The topic of this post is an essay by Joseph Heath on 'The Benefits of Cooperation (pdf)'

Heath posits that there are 5 different ways that people can benefit by working together:
1) Economies of Scale
2) Benefits from trade
3) Risk sharing
4) Self-binding
5) Information sharing

Heath notes that the first theorem of welfare economics demonstrates that competitive markets (which achieve benefits by allowing people to trade with one another) will achieve a perfectly efficient outcome, but that the assumptions behind the theorem rule out all other forms of cooperation:

"The 'invisible hand theorem' (or 'first fundamental theorem of welfare economics'), shows that the competitive equilibrium of a market economy will be Pareto-optimal as long as certain 'standard' conditions obtain. The list is quite long, but includes inter alia constant returns to scale, individuals with well-behaved utility functions, symmetric information, a complete set of futures markets, and in cases of
uncertainty, a complete set of insurance markets.

In other words, the theorem shows that markets achieve perfect efficiency, so long as every other mechanism of cooperative benefit is excluded from consideration – either by assuming that no such benefits are possible, or that all such benefits are freely available. To see how uninformative this is, consider how we would respond
to someone who proposed a model for the 'optimal' production of scientific knowledge, based upon the assumption that both material resources and labor were available in unlimited supply and at zero cost. Whatever its technical merits, such a model would give us very little assistance with real-life policy questions."

Heath goes on to point out how circumstances often force us to choose between pursuing different types of benefits. In the case of economies of scale, there is an obvious conflict between having a large number of firms to make a market more competitive, and having a smaller number of firms so that the bigger firms can achieve greater economies of scale. It's worth nothing that, due to network externalities, any organization that physically extends across geographic territory (i.e. power grid, sewer system, road network) tends to be operated as a monopoly, with the economies of scale overwhelming the gains from competition leading to more trade in this particular case.

The story (conflict between benefits from trade vs. benefits from other forms of cooperation) is similar with risk sharing. Heath gives the example of the enclosure of the commons that occurred in England prior to the industrial revolution. Allowing individuals to take ownership of parts of the commons created far more opportunity for specialization and trade to take place by ensuring that anyone who took the trouble to improve or develop a piece of land could expect to reap most of the benefits from their efforts, rather than sharing them with everyone else in the commons. But the commons system provided a great benefit by insulating individuals from the uncertainties of having their fortunes entirely dependent on one piece of land. Splitting the land into privately owned chunks removed the benefit that arises from reducing uncertainty for individuals by diversifying risks across a large group of people.

By self-binding, Heath means situations where we want to pre-emptively prevent ourselves from taking actions we know we will regret (due to hyperbolic discounting) and enlist others to aid us. The thought reminds me of this passage from Plato's Republic,

"Tell me then, O thou heir of the argument, what did Simonides say, and according to you truly say, about justice?

He said that the repayment of a debt is just, and in saying so he appears to me to be right.

I should be sorry to doubt the word of such a wise and inspired man, but his meaning, though probably clear to you, is the reverse of clear to me. For he certainly does not mean, as we were just now saying, that I ought to return a deposit of arms or of anything else to one who asks for it when he is not in his right senses; and yet a deposit cannot be denied to be a debt.

True.

Then when the person who asks me is not in his right mind I am by no means to make the return?

Certainly not.

When Simonides said that the repayment of a debt was justice, he did not mean to include that case?

Certainly not; for he thinks that a friend ought always to do good to a friend and never evil.

You mean that the return of a deposit of gold which is to the injury of the receiver, if the two parties are friends, is not the repayment of a debt,—that is what you would imagine him to say?

Yes."

On the topic of self-binding, Heath makes the same analogy between borrowing and substance abuse that I did in last week's post,

"Economist David Laibson has argued that financial innovation, by increasing the overall liquidity of assets, has made it increasingly difficult for individuals to create 'golden eggs.' The difference between savings and checking accounts has become purely nominal; the introduction of ATMs has meant that everyone has access to their money at all hours (and so withdrawing a fixed amount at the beginning of the week can no longer be used as a self-control mechanism); reverse mortgages allow people to drain the asset value of their homes; and, of course, consumer credit has rendered the practice of 'saving up' for a major purchase almost obsolete. This sort of 'easy money' is a mixed blessing to consumers, in the same way that a 24-hour beer store is a mixed blessing to the alcoholic."

Again, making it easier to complete trades conflicts with a different form of cooperative benefit.

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What this notion of 5 different forms of cooperative benefits means with regard to the two syndromes identified by Jacobs is not entirely clear to me. The view I'm drifting towards is that the guardian syndrome represents cases where perfect monopoly is required and the commercial syndrome represents something close to the perfect competition ideal.

Cases where economies of scale are all that matters would seem to lead to a monopoly which would fall under the guardian syndrome. Cases where there the benefits to risk sharing far outweigh gains from trade would be similar. Self-binding relies on a hierarchical relationship (the one who is binding themselves submits to the authority of the person who will bind them) such as we find in the guardian syndrome and measures to encourage the generation of new information (intellectual property) often seem to do so by guaranteeing a monopoly to the producer of the information.

Cases where gains from trade need to be balanced against one of these other sources of cooperative benefit would seem to involve a grey area of competition mixed with monopoly in some measure. Perhaps it's not surprising that these areas tend to be an ongoing source of controversy.

30. The Moral Conditions of Economic Efficiency

Note: This post is the thirtieth in a series. Click here for the full listing of the series.

The next few posts will discuss the book, 'The Moral Conditions of Economic Efficiency', by Walter Schultz. It is a similar book to 'Morals by Agreement' by David Gauthier in that it looks into what morals would be needed to achieve economic efficiency under conditions of perfect competition (recall that Gauthier argued that a market under perfect competition was a 'moral-free zone').

In, The Moral Conditions of Economic Efficiency, Walter Schultz sets out to show that the 'invisible hand' (as encoded mathematically in the First Theorem of Welfare Economics) won't function without the participants in the market having some moral constraints on their behaviour. It does this by constructing an abstract representation of the world containing what Schultz refers to as 'Strict Rational Egoists' (i.e. people who follow the narrow version of self-interest as discussed back in this post) and showing that market interaction of these 'strict rational egoists' would not lead to (pareto) efficient outcomes.

It's an academic book, and the material is pretty abstract, so I thought I'd offer a more concrete example before launching in to a summary of the argument in the next couple of posts.

---

The pilot to Joss Whedon's short-lived cowboys in space TV series Firefly opens with Mal, captain of an outlaw trading vessel, and his crew 'salvaging' some valuable cargo (condensed food) from a wrecked ship.

Later on in the show we find out that the food has been stamped with a government sign so the original buyer backs out and now Mal needs to find a new buyer. Given that the cargo was obtained illegally and is marked as such, both sides to the transaction will have to be outlaws, or in other words, the exchange will take place without any formal constraints in the form of government oversight or legal penalties for rule breaking. And since both sides to the transaction are outlaws and rule-breakers so they can't be expected to hold to any particular moral code themselves.

A process of elimination leads Mal and his crew to the conclusion that the only person ¹who might buy their goods is Patience, the local ruler of an out of the way moon, notwithstanding the fact that the last time they met, she shot Mal.

Arriving on the moon, Mal and his crew first bury their cargo so that it can't simply be taken from them by force. Then Mal tells his henchman to take out the snipers Patience will have waiting for them in ambush, warning him, "Don't kill anyone you don't have to, we're here to make a deal²"

When Mal and his second in command come face to face with Patience, who has brought a number of men with her, Patience suggests that she brought the extra men because she was concerned that Mal might be motivated by vengeance, but he replies that he is 'just doing the job, not looking for surprises'.

Mal tosses Patience one piece of their cargo (food) to prove they have a real cargo, and then Patience tosses Mal the money (the tossing helps keep a safe distance between them). Mal tells Patience the location of the cargo and then suggests he'd prefer it if Patience left first (not wanting to turn his back and get shot).

Patience tells him there's a hitch, and Mal replies, 'we both made out on this deal, don't complicate things' (i.e. the deal was pareto-efficient, so there's no cause for greediness)

Patience tells him she has a rule that she never lets go of money she doesn't have to. In reply, Mal tosses the money back to Patience, meaning they could just part without making a deal at all.

Despite his offer, violence erupts, Mal's side is victorious and he ends up standing over Patience with a gun pointed at her. But instead of shooting her, he simply takes back his money, commenting that, "I do the job, and then I get paid".

So the transaction ends up being entertaining, but it is not very efficient in the sense that a lot of resources were used on both sides (burying the cargo, bringing accomplices, shooting people and horses, etc.)that wouldn't have needed to be used if they could have just trusted each other.

Its the sort of inefficiency that led Hobbes to conclude that life in a state of nature would be 'nasty, brutish and short' but note that the transaction does end up meeting Schultz's definition of efficiency, since both sides benefit from the exchange - Patience gets the food and Mal gets the money (since both parties are better off after the exchange, it is Pareto efficient).

But note that the only reason the outcome turns out this way is due to the moral code followed by Mal, wherein even though he had the opportunity to take his money and keep his cargo as well, he chose to make the exchange as if it had been made honestly and without resort to force by either side. So although both sides apply force and fraud in their dealings with each other, Mal and company are applying those in the service of achieving an efficient exchange which benefits both parties, whereas Patience and her henchmen are employing force and fraud in an attempt to achieve a Pareto-inefficient exchange that benefits them at the expense of Mal and his team.

In a nutshell, what Schultz ends up arguing in The Moral Conditions of Economic Efficiency is that an economy composed only of people like Patience, who 'never give up money when they don't have to' will lead to economic inefficiency and only by adding in people like Mal who restrain themselves from 'strict rational egoism' (taking what they can get) based on normative constraints (i.e. moral rules) can the 'invisible hand' work to achieve a pareto efficient distribution of goods.

Schultz does this by first establishing precisely what it means for someone to be a 'strict rational egoist' and then showing how the proof of the first welfare theorem fails to hold if participants in a market are strict rational egoists.

Having done that, he then goes on determine just what sorts of normative constraints are required to make a market work (Pareto) efficiently. But those are topics for subsequent posts.

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¹This is a violation of one of the conditions of the first welfare theorem and perfect competition - that there are multiple buyers and sellers, but even if there were more options, it's hard to see how that really changes the point much in this particular instance.

²The comment reminds me of Jane Jacobs, describing how Moses distinguished between when the Israelites have been a military force, 'killing and pillaging their way through territories' and when they instead bought passage through other people's territory and that in these cases they should stick to the highway, 'invading neither left nor right, taking heed to their good conduct'.