How Honesty Pays in Business

There exist the popular perception that markets fail because business is full of dishonest scoundrels – especially high ranking executives -- who cheat, lie, steal, and worse to increase their profits.  This perception is reflected in and reinforced by the way business people are depicted in the media. According to one study, during the 1980s almost 90 percent of all business characters on television were portrayed as corrupt

The case to be made for honesty in business is not based on any claim that business people are particularly virtuous, or ethical to the core of their beings.  We can make no claim to keen insights into the virtue of business people or anyone else.  We might even be persuaded that business people have less virtue on average than do those who choose more caring occupations, such as teachers, social workers, missionaries, and nurses.  But we do claim to know one simple fact about human behavior, and that is people respond to incentives in fairly predictable ways.  In particular, the lower the personal cost of dishonesty, the greater the extent of dishonestly within most identified groups of people.  If business people act honestly to an unusual degree (or different from what other people in other situations do), it must be in part because they expect to pay a high price for be­having dishonestly. This is, in fact, the case because business people have found, some­what paradoxically, that they can increase profits by accepting institutional and contractual arrangements that impose large losses on them if they are dishonest.

Though seldom mentioned, most business activity requires a high degree of honest behavior. If business is going to be conducted at any but the simplest level, products must be represented honestly, promises must be kept, costly commitments must be made, and business people must cooperate with each other to take the interests of others, particularly consumers, into consideration.  Indeed, if the proverbial man from Mars came down and observed business activity, he might very well conclude that business people are extraordinarily honest, trusting, and cooperative.  They sell precious gems that really are precious to customers who cannot tell the difference between a dia­mond and cut glass. They promise not to raise the price of a product once customers make investments that make switching to another product costly, and they typically keep the promise. They make good faith pledges that the businesses they own, but are about to sell, will continue to give their customers good service.  They commit themselves to costly investments to serve customers knowing the investments will become worthless if customers shift their business elsewhere.

The way business people behave in the marketplace suggests a level of morality that is at variance with the self-interest that economists assume, in their theoretical models, motivates business activity. Some argue that the economist’s assumption of self interest is extreme, and we recognize that many people, including many business people, behave honestly simply because they feel it is the right thing to do. But few would recommend that we blindly trust in the honesty of others when engaged in business activity. The person who is foolish enough to assume that all business people are honest

It is easy to imagine a situation in which business people can profit at the expense of their customers, workers, and others with whom they deal if they behave deceitfully.  For example, the quality of many products (say used cars or diamonds) is difficult for consumers to easily determine.  The seller who takes advantage of this by charging a high quality price for a low quality product would capture extra profits from the sale.  A business owner who is about to retire can profit by making promises not to be fulfilled until after his retirement, and which he does not plan to keep. The monopoly producer of a superior product (but one which requires the consumer to make costly investments in order to use it) can offer the product at a low price and then, once the consumer becomes dependent on it, increase the price significantly.  Other examples of the potential profit from dishonest behavior are easily imagined.  In fact, such examples are about the only type of behavior some people ever associate with business.

A businessperson who attempts to profit from dishonest dealing faces the fact that few people are naively trusting. It may be possible to profit from dishonesty in the short run, but those who do so find it increasingly difficult to get people to deal with them in the long run. And in some businesses it is extremely difficult to profit from dishonesty even in the short run. How many people, for example, would pay full price for a “genuine” Rolex watch, or diamond necklace, from someone selling them out of a Volks­wagen van at the curb of a busy street?  Without being able to provide some assurance of honesty, the opportunities to profit in business are very limited.

So business people have a strong motivation to put themselves in situations in which dishonest behavior is penalized.  Only by doing so can they provide potential customers, workers, and investors with the assurance of honest dealing required if they are to become actual customers, workers, and investors.

The advantage of honesty in business can be illustrated by considering the problem facing Mary who has a well-maintained 1990 Honda Accord that she is willing to sell for as little as $4,000. If interested buyers know how well maintained the car is,

So the mix of 1990 Accords for sale will tilt more in the direction of poorly maintained cars, their expected value will decline, and even fewer well-maintained 1990 Accords will be sold. This situation is often described as a market for “lemons,” and illustrates the value of sellers being able to commit themselves to honesty.

Choosing the Most Efficient Remedy for Externalities

selecting the most efficient method of minimizing externalities can be a complicated process. To illustrate, we will compare the costs of two approaches to controlling pollution, government standards versus property rights

Suppose five firms are emitting sulfur dioxide, a pollutant that causes acid rain. The reduction of the unwanted emissions can be thought of as an economic good whose production involves a cost.  We can assume that the marginal cost of reducing sulfur dioxide emissions will rise as more and more units are eliminated. We can also assume that such costs will differ from firm to firm. Table 7.1 incorporates these assumptions. Firm A, for example, must pay $100 to eliminate the first unit of sulfur dioxide and $200 to eliminate the second. Firm B must pay $200 for the first unit and $600 for the second. Although the information in the table is hypothetical, it reflects the structure of real-world pollution clean-up costs.  The technological fact of increasing marginal costs faces firms when they clean up the air as well as when they produce goods and services.

Suppose the Environmental Protection Agency (EPA) decides that the maximum acceptable level of sulfur dioxide is ten units.  To achieve that level, the EPA prohibits firms from emitting more than two units of sulfur dioxide each. 

Remember that the EPA can control the number of tickets it sells.  To limit pollution to the maximum acceptable level of ten units, all it needs to do is sell no more than ten tickets. Either way, whether by pollution standards or rights, the level of pollution is kept down to ten units, but the pollution rights method allows firms that want to avoid the cost of a cleanup to bid for tickets.

The potential market for such rights can be illustrated by conventional supply and demand curves. The supply curve is determined by EPA policymakers, who limit the number of tickets to ten. Because in this example the supply is fixed, the supply curve must be vertical (perfectly inelastic). Whatever the price, the number of pollution rights remains the same. The demand curve is derived from the costs firms must bear to clean up their emissions. The higher the cost of the cleanup, the more

At a price of $1,500 per ticket, firm A will buy one and only one ticket. At that price, it is cheaper for the firm to clean up its first four units (the cost of the cleanup is $100 + $200 + $400 + $800). Only the fifth unit, which would cost $1,600 to clean up, makes the purchase of a $1,500 ticket worthwhile. Similarly, firm B will buy three tickets, firm C none, firm D two, and firm E four.

The cost of any cleanup must be measured by the value of the resources that go into it. The value of the resources is approximated by the firm’s expenditures on the cleanup—not by their expenditures on pollution tickets.  (The tickets do not represent real resources, but a transfer of purchasing power from the firms to the government.)  Accordingly, the economic cost of reducing pollution to ten units is $9,300; $1,500 for firm A. $800 for B, $3,000 each for C and D, and $1,000 for E

The idea of selling rights to pollute may not sound attractive, but it makes sense economically.  When the government sets standards, it is giving away rights to pollute. In our example, telling each firm that it must reduce its sulfur dioxide emissions by three units is effectively giving them each permission to dump two units into the atmosphere.  One might ask whether the government should be giving away rights to the atmosphere, which has many other uses besides the absorption of pollution. Though some pollution may be necessary to continued production, that is no argument for giving away pollution rights. Land is needed in may production processes, but the Forest Service does not give away the rights to public lands. When pollution rights are sold, on the other hand, potential users can express the relative values they place on the right to pollute.2 In that way, rights can be assigned to their most valuable and productive uses.

Market Failures External Costs and Benefits

In its broadest definitional sense, collective action is the enactment and enforcement of law. The justification for all collective action, for government, lies in its ability to make men better off.  This is where any discussion of the bases for collective action must begin.

James Buchanan

Howmuch should government involve itself in the marketplace? How much does business want government involvement.” These questions touch on one of the most important economic issues of our time: the division of responsibility between the public and private sectors. In general, economic principles would suggest that government undertake only functions that it can perform more efficiently than the market.  As we will see, businesses are not always opposed to government involvement in the economy. Indeed, many businesses have incentives to try to make sure that government is more involved in the economy than is “efficient.”

Economics provides a method for evaluating the relative efficiency of government and the marketplace. It enables the United States to identify which goods and services the market will fail to produce altogether, and which it will produce inefficiently. We saw in an earlier chapter that such market failures have three sources: monopoly power, external costs, and external benefits. Now, using the principles and graphic analyses developed in earlier chapters, we will take a closer look at external costs and benefits and at government attempts to capture them and correct market failures.  

In a competitive market, producers must minimize their production costs in order to lower their prices, increase their production levels, and improve the quality of their products. Consumers must demonstrate how much they will pay for a product, and in what amount they will buy it. In a competitive market, production will move toward the intersection of the market supply and demand These results cannot be achieved unless competition is intense, buyers receive all the product’s benefits, and producers pay all the costs of production.  If such optimum conditions are not achieved, the market fails. Part of the excess benefits shown by the shaded area in the figure will not be realized by either buyers or sellers. When exchanges between buyers and sellers affect people who are not directly involved in the trades, they are said to have external effects, or to generate externalities. Externalities are the positive or negative effects that exchanges may have on people who are not in the market. They are third-party effects.  When such effects are pleasurable they are called external benefits. When they are unpleasant, or impose a cost on people other than the buyers or sellers, they are called external costs. The effects of external costs and benefits on production and market efficiency can be seen with the aid of supply and demand curves. Producers may not bear all the costs associated with production, however.  A by-product of the production process may be solid or gaseous waste dumped into rivers or emitted into the atmosphere. The stench of production may pervde the surrounding community. Towns located downstream may have to clean up the water. People may have to paint their houses more frequently or seek medical attention for eye irritation. Homeowners may have to accept lower prices than usual for their property. All these costs are imposed on people not directly involved in the production, consumption, or exchange of the paper product. Nonetheless, these external costs are part of the total cost of production to society. In a perfectly competitive market, in which all participants act independently, survival may require that a producer impose external costs on others. An individual producer who voluntarily installs equipment to clean up pollution will incur costs higher than those of its competitors. It will not be able to match price cuts, and so in the long run may be out of business -- and some producers may not care whether they cause harm to others by polluting the environment. Even socially concerned producers cannot afford to care too much about the environment. Government dictates in educational institutions have sometimes imposed onerous costs on students. For instance, until the late 1960s, the University of Virginia had a dress code that required male students to wear coats and ties. Colleges routinely set the hours by which students should return to their dormitories and expelled those who rebelled. At the University of California, students were once forbidden to engage in on-campus political activity. Costs are imposed on those who must obey such rules. The more centralized the government that is setting the standards, the less opportunity people will have to escape the rules by moving elsewhere. In certain markets, government action may not be necessary. Over the long run, some of the external costs and benefits that cause market distortions may be internalized. That is, they may become private costs and benefits.  Suppose the development of a park would generate external benefits for all businesses in a shopping district. More customers would be attracted to the district, and more sales would be made. An alert entrepreneur could internalize those benefits by building a shopping mall with a park. Persuasion External costs arise partly because we do not consider the welfare of others in our decisions. Indeed, if we fully recognized the adverse effects of our actions on others, external cost would not exist. Our production decisions would be based as much as possible on the total costs of production to society. Thus government can alleviate market distortions by persuading citizens to consider how their behavior affects others.  Forest Service advertisements urge people not to litter or to risk forest fires when camping. Other government campaigns encourage people not to drive if they drink, to cultivate their land so as to minimize erosion, and to conserve water and gas. Although such efforts are limited in their effect, they may be more acceptable than other approaches, given political constraints. Persuasion can take the form of publicity. The government can publish studies demonstrating that particular products or activities have external costs or benefits.  The resultant publicity may in turn encourage those activities with external benefits and discourage those activities with external costs. The government has, for example, used this method in the case of cigarettes, publishing studies showing the external costs of smoking. Government production can be a mixed blessing. When other producers remain in the market, government participation may increase competition. Sometimes it means the elimination of competition. Consider the U.S. Postal Service, which has exclusive rights to the delivery of first-class mail.  As a government agency, the Post Office is not permitted to make a profit that can be turnover to shareholders. Because of its market position with little competition for home delivery of mail, however, it may tolerate higher costs and lower work standards than competitive firms. Some government production, such as the provision of public goods like national defense, is unavoidable. In most cases, however, direct ownership and production may not be necessary. Instead of producing goods with which externalities are associated, government could simply contract with private firms for the business. That is precisely how most states handle road construction, how several states handle the penal system, and how a few city governments provide ambulance, police, and firefighting services.