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.