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William Kline
In business ethics the concept of “business” is just as important as “ethics” in determining what businesses ought to do. What business is constrains what it can do. If “ought” implies “can,” then the answer to “What is business?” sets the parameters for what business ought to do. Our problem is that much like “ethics,” there are different theories about, and meanings of, “business.”
In the early seventeenth century, in his Novum Organum (1620), Francis Bacon warned against judgment biases arising from the natural looseness of words. Words mean different things to different people, and this leads to personally biased conclusions as well as fruitless debates as people using the same word are actually talking or writing about distinct things—the proverbial apples and oranges. Bacon aptly names these judgment biases, “Idols of the Market.” Such biases are idols of the market because they arise out of ambiguities in communication and, apparently, Bacon thought nothing symbolizes this better than the hurley-burley exchanges and negotiations of a seventeenth-century market. Bacon’s warning has relevance to the understanding of business. In order to avoid confusion, business ethicists must choose, articulate, and argue for a theory of business just as they do with ethics. Given the richness of the term and actual practice of business, this is no easy task.
The Oxford English Dictionary lists at least twenty-two entries for “business,” thereby reaffirming Bacon’s apt nomenclature. Nonetheless, this list of entries is finite, so the meaning of “business” has boundaries: not everything is business. Clarifying what constitutes these boundaries will help us to better identify what should and should not count as business, and why.
To organize the discussion, I will use the observation of Al Gini and Alexei Marcoux (2012) that “business” can refer to both organizations and activities. Accordingly, this chapter will first examine two prominent views of business as an organization: business may be identified with corporations or it may be understood in terms of a theory, the transaction costs theories of the firm. I will argue that both are deficient conceptions of business. Consideration will then be given to business as an activity. I will argue that rules define the scope of business activities. Activities that violate these rules are not merely unethical, they are not business at all. I then explore how these rules provide the bases for what business is: attempting to profit by producing a good or service for trade. The final section of this chapter will examine the implications of stakeholder theory for our very understanding of business as an activity.
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Business as the corporation
In the business ethics literature, and in popular critiques, the organizational structure overwhelmingly identified as business is the large publicly traded corporation. Robert Solomon captures the essence of this focus: “the consequences of the activities of a giant corporation are always so pervasive and powerful that, unlike similar actions by a smaller company, virtually everything it does becomes an ethical issue” (1997: 50–51, see also Solomon 1999; Hasnas 2013). Archie B. Carroll (1999) points to the same fixation on the corporation in his account of how the concept of “social responsibility” in business ethics evolved, from the 1950s to the end of the 1990s, into the idea of corporate social responsibility. As to why this change occurs he notes only that, “In the early writings on CSR, it was referred to more often as social responsibility (SR) than as CSR. Perhaps this was because the age of the modern corporation’s prominence and dominance in the business sector had not yet occurred or been noted” (1999: 269). According to Zhenzhong Ma, from 2002 to 2006 the most influential papers published in business ethics shifted their focus to corporate social responsibility and corporate performance (2009: 258). The framing of this issue as one of corporate social responsibility combined with the publication and citation of influential articles on corporate social responsibility mutually reinforce each other. The end result is that the business ethics literature tends to focus on the large publicly traded corporation. As Richard DeGeorge (2015) has put it, “business ethics sought to provide an explicit ethical framework within which to evaluate business, and especially corporate activities.”
Two major background arguments serve as the foundation underlying the focus on the corporation. The first argument involves the proposition that we no longer live in Adam Smith’s world of small shopkeepers (Solomon 1997: 304). The second involves the supposed observation that large corporations have far greater effects on people’s lives than single small proprietorships. We shall examine each of these arguments in turn and find them both wanting.
The claim that we are no longer a nation of small shopkeepers does not stand up to careful scrutiny. According to business census data there are close to as many jobs provided by firms hiring 500 and fewer employees as there are persons employed by firms larger than 500 (Caruso 2015). In the United States approximately 56.1 million people earn their living in firms of less than 500 employees. To assert that we now have corporations larger than Adam Smith ever conceived also overlooks that we have far more small businesses than he had ever known possible. Assuming away the real statistical distribution of extant business organizations is not a justification for disproportionately focusing on large publicly traded corporations.
This leaves us with the claim about relative impacts. There is truth to the claim that scholarly focus on large publicly traded corporations is justified due to their potential influence relative to that of a small firm. The actions or policies of one very large firm will have greater ramifications than those of one very small firm. If the local steel mill or coal mine closes, the local town is in for a great deal of misery, but not so if the local hardware store closes. When Union Carbide makes a mistake with chemicals, as it did in Bhopal, India 1984, thousands are hurt or killed. This scale of impact does not occur with local “mom and pop” shops, or so the argument goes.
The argument about influence or impact overlooks how business ethics should consider not just the corporate firm but the actions of individuals and small businesses, as well as the effects of collective action, especially those resulting from laws and government policies. Millions of people are employed and pay taxes due to mid- and small-size firms. Moreover, licensing, taxing, zoning, minimum wage, and other policy decisions have a broad impact on small businesses, an influence that is left largely unnoticed due to the focus on large corporations. For example, in 2007, almost a million Mattel toys were recalled due to the presence of lead (Story 2007). This incident served as the justification for Congress to pass the Consumer Product Safety Improvement Act (CPSIA), which purportedly imposed stricter testing standards for toys. However, with the focus on large corporations it has been largely overlooked how, with the imposition of stricter testing standards, many smaller toy companies, that never had these problems, went out of business due to the high costs of compliance (Wayne 2009). Comparing a single large firm to a single small company, for purposes of measuring “impact,” is a mistake. Laws, regulations, and ethical judgements usually do not apply only to a single firm whether large or small. In consequentialist reasoning, it is essential to take into account the totality of effects that may occur, an entirely contingent and empirical matter that depends upon a host of factors that go beyond the single data point concerning the size of a single company. Although the standard reasons for examining corporations may be important, they are poor reasons for ignoring the other half of the economy.
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Business is more than large publicly traded corporations. Business includes firms of many sizes and legal forms. So any account of business should identify all of these firms as a type of organization, a business organization that is structurally or functionally different from other organizations that are not seen as a business. Transaction cost theory, while often eschewed by ethicists, holds the promise of identifying certain economic elements that distinguish an organization as a business regardless of size. Given its stature and prevalence, this theory cannot be ignored in the quest to examine what business as an organization is. The next section explores this theory on its own terms; although there is much to learn from it, such a theory of the firm is not, in fact, a theory of business.
The theory of the firm—and business
A transaction cost theory of the firm explains the existence of “firms” in terms of how expensive it is to conduct all transactions within the open market. According to Ronald Coase, it is the existence of such transaction costs that explain the existence of firms (1937a). Broadly understood, transaction costs are the costs of coordinating individuals to complete a task in the market; these include, but are not limited to, the price of locating people, negotiating individual contracts, and the costs of ensuring compliance with those contracts.
To overcome these costs firms make contracts with employees to place them under the authority of managers who then may, within the limits set by the contract, order the employee to perform various tasks. This is why, for Coase, “The essence of the contract is that it should only state the limits to the power of the entrepreneur” (1937a: 391). Once the contract allows for discretionary authority—authority to allocate resources not based on prices but on the judgment of the entrepreneur or manager—the transaction is no longer within the market. By this reasoning even two people can constitute a firm if the contract allows for discretionary authority.
There is a problem, though, if the presence of discretionary authority, the “supersession of the price mechanism,” (1937a: 389) is the hallmark of the firm. In fact, a focus on discretionary authority actually blurs the line between market transactions and transactions within the firm, since every contract between buyer and seller (not just employer and employee) embodies some form of discretionary authority. To see this let us consider two simple examples. In the first example you hire someone to clean your house. You stipulate each task, research the price for each task, sum these discrete prices, and offer a specific total price for someone to do those exact tasks; you then find a person who will do those tasks for that price. Allowing for the fact that those willing to do the work may try to negotiate, this example captures many of the costs Coase associates with market transactions and is a feasible example of what he considers a market transaction. Consider a second example. In this case you advertise for a cleaner, stipulating that only house cleaning is involved and perhaps other limitations to what you can ask of the potential employee. You go into the market and advertise, negotiate, and find someone who will do all those tasks allowed within the scope of the contract. Although the act of hiring the person is conducted according to the price mechanism, all future interactions involve you telling the cleaner what to do, thereby substituting your authority for price allocation. This latter example exhibits the nature of the firm, albeit in the limiting case of two individuals.
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The problem these examples generate is that the nature of a task and of a price is not a given natural fact. With regards to the first example, it is doubtful that any task can be so completely described as not to require some direction outside of contractual stipulations. Contracts are always incomplete. Furthermore, it would seem that a contract would stipulate, in the case of ambiguity, whose judgment must be consulted. There are issues the contracting agent is free to decide on his own, and there are others that will require the decision of the principal. Take the cleaning example again: the meaning of the term “clean”—its operational implications—is subject to the judgment of both the principal and agent. Some areas may be so important for the principal that both principal and agent carefully inspect the agent’s work to make sure the principal’s standard is met. Such scrutiny, though, is not possible for the entire area being cleaned and in those areas it is the judgment of the cleaner that, effectively, prevails. Both principal and agent exercise discretionary authority over resource allocation. Even for market contracts, as represented by Coase, discretionary authority is present and hence there is supersession of the price system. Therefore, if discretionary authority is present in any contract, then by this account any contract constitutes a firm; however, if this is the case, then the presence of discretionary authority within contracts does not distinguish the firm from the market.
Coase posits discretionary authority as the defining element that removes contracts from the market and places them within the firm. However, as we have just seen, this does not provide a clear distinction between the firm and the market. Another possibility for distinguishing the firm from the market arises from the fact that all contracts are incomplete. Since all contracts are incomplete, principals must monitor performance to ensure contracts are executed in a manner that satisfies the principal’s interests. Such monitoring, which itself is a transaction cost, is minimized (or reduced) if it is done within a firm. Therefore, it is argued, the firm exists precisely because it is the organizational means of ensuring contractual compliance. To focus on the subset of transaction costs related to ensuring contractual compliance is to work within the ambit of agency theory. If transaction costs are what separate the firm from the market, then it may be that agency theory’s focus on the costs of compliance provides the defining feature(s) of the firm.
Oliver Williamson argues, like Coase, that transaction costs are the reason firms exist. Unlike Coase, though, Williamson argues that it is because of monitoring and enforcement costs that firms take transactions out of the market and place them within the firm (1975, 1985). The need to monitor and enforce contracts thus becomes the distinguishing feature of the firm. However, as we have seen with the example of the cleaner, the need for monitoring does not end at making contracts that supposedly take transactions out of the market. Agency theory steps in to argue that monitoring is necessary within the firm as well because agents still face opportunities to advance their own interests at the expense of the principal. Jensen and Meckling argue that “positive monitoring . . . costs will result in the manager of a corporation possessing control over some resources which he can allocate (within certain constraints) to satisfy his own preferences” (1976: 309). This is apparently why Joseph Heath calls business a “criminogenic” environment (2008, 2009): opportunities for cheating, theft, and self-dealing supposedly abound within the firm. On a slightly less criminal note, Armen Alchian and Harold Demsetz contend that it is the problem of shirking in teams that necessitates monitoring and the organization of the firm (1972: 782). Differences in interests between principles and agents give rise to the necessity of spending resources on performance monitoring and contract enforcement even within the firm. These “agency problems” are a particularly important subset of the transaction costs used to explain the nature of the firm.
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Some business ethicists counter that agency theory, with its focus on contract monitoring and compliance, is a morally deficient conception of the firm. Critics argue that the agency problems postulated by agency theory arise out of the unwarranted assumption that agents are egoistic utility maximizers. “Agency theorists act as if all people are psychological egoists. They assume that agents will act on their own behalf rather than on behalf of their principals for whom they are agents” (Bowie 2013: 32, see also Ghoshal and Moran 1996: 17). According to Ian Maitland et al., “Williamson’s market strikingly resembles Hobbes’s state of nature” (1985: 61). Apparently, it is this incorrect model of human behavior that then leads to an incorrect, unethical, understanding of the firm.
Critics are correct that a utility maximization model of human nature is present within the agency theory literature. (For example see Jensen and Meckling 1976: 308). In fact, the assumption goes back much farther. In the business literature, Adolf Berle and Gardiner Means (1933) are often credited with the original observation of the divergence in interests between principals and agents because of the profit motive, i.e., self-interest. In philosophy the argument that everyone would cheat dates back as far as Plato’s dialogue Republic with its tale of the Ring of Gyges. One of the interlocutors, Glaucon, tells the story of a Lydian Shepherd, the agent, who discovers a ring of invisibility he uses to satisfy his own preferences by assassinating the king, the principal, and taking over the kingdom. While Glaucon argues that nobody would do any differently than act like the Lydian Shepherd, we need not make the assumption of universal egoism for agency problems to be real. The ring is not imaginary, it is metaphorical. Master keys, computer knowledge, promotions to the executive ranks, and business trips all bring with them reduced monitoring and associated risks.
While there is a rich history of assuming agents are psychological egoists, the business ethics critique falls short of the mark and is not the real reason we should reject agency theory (or transaction costs) as the defining theory of the firm. The need for monitoring does not rest on everyone being a cheat. Human nature could be mostly “good” but it only takes a certain percentage of “bad apples” to hurt or ruin a business. Ghoshal and Moran, reach the same conclusion: Transaction costs theory “does not require that all individuals are so inclined, but only that some, sometimes, are” (1996: 19). Joseph Heath argues similarly that rationality does not require egoism, even if “agency theorists often do make unflattering empirical assumptions about individual preferences” (2009: 500). Egoism, Heath argues, is not the problem. Two altruists with different opinions of what constitutes the good would still face an agency problem. “[W]hat creates the need for incentives in principal–agent relations, strictly speaking, is not the fact that the principal and the agent have egoistic preferences, but merely the fact that they have different preferences (2009: 500, original emphasis). The conclusion that firms must monitor and enforce contracts requires only a reasonable assessment of interest divergence and a sufficient estimated risk of harm such a divergence can cause, not the universal assumption that human nature is necessarily cutthroat. Contract monitoring and enforcement are essential within the firm even without the morally dubious assumption of utility maximization. The real reason for rejecting agency theory (and thus the transaction costs view) as a defining notion of the firm lies elsewhere.
The tendency of some transaction costs theorists to focus on agency problems conveys the impression that preventing self-dealing is the core problem that defines business. The firm exists to monitor and enforce the performance of contracts. Even critics of these theories, like Heath, seem to subscribe to the notion that self-dealing is somehow a more urgent problem in business than in other walks of life. What philosophy shows us, though, is that this problem is not unique to business. Governments, nonprofits, and almost any human interaction present opportunities for acting on divergent interests. There is no empirical evidence to show that business organizations are any more “criminogenic” than any other organization. Business organizations may need to monitor agents, but for the same reasons so do non-business organizations. The monitoring of contracts neither distinguishes the firm from the market nor distinguishes business from other hierarchical non-business firms. Transaction costs as captured in agency theory do not provide the distinguishing characteristic(s) of business as opposed to other types of organizations and therefore should be rejected as providing an account of what a business organization is. The economic theory of the firm, therefore, is not a theory of business.
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What makes an organization “business” is not a function of size, legal form, the presence of discretionary authority to allocate resources outside the price system, or the need to monitor contractual performance. In order to tell if an organization is a business organization we need to look more at the activities of the organization and what people do in these organizations. As Alexei Marcoux states: “Business firms differ from other kinds of organizations not principally in their organizational features, but in what they are organized to do—business” (2006: 57). We need to examine business as an activity.
Rules and activities
Business exists because certain normative rules classify the actions that define the practice of business. For example, Joseph Heath argues that the principal–agent relationship is not simply an empirical matter, but must be defined in terms of who ought to be served and who ought to serve. “It is not clear . . . [that] the ‘principal–agent’ relationship can ever be normatively neutral” (2009: 505). Once the rule is set the proper action of who serves whom is defined. Legal theorist H.L.A. Hart makes the same point with respect to signing contracts: Rules concerning what constitutes a proper signature tell people how to write their name such that it constitutes the signing of a contract and not merely scribbling (1961: 28). Douglass North argues that institutions set “the rules of the game in society” (1990: 3) and thereby set the context of exchange and contract.
A hierarchy of rules—constitutional, statute law, common law . . . —together will define the formal structure of rights in a specific exchange. Moreover, a contract will be written with enforcement characteristics of exchange in mind. Because of the costliness of measurement, most contracts will be incomplete; hence informal constraints will play a major roles (sic) in the actual agreement. These will include reputation, broadly accepted standards of conduct . . . and conventions that emerge from repetitive interaction.
(North 1990: 61)
Rules, both formal and informal, determine what activities count as business, hence an examination of what activities constitute business is, in part, an examination of these rules. These rules do not exhaust the concept of business, but any examination of the nature of business activity is certainly incomplete without their examination.
Business exists within the market, and even if it may be regulated by a state it is not an institution of the state.1 Business is an institution of the market. A market is not a place, it is a normative stipulation of the rules of a certain type of engagement.
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The market is where people go to buy, sell, truck, and barter. In short, the market is the realm of voluntary exchange. As such, coercion—the use or threat to use physical force to attain one’s ends—is definitionally outside the bounds of market activity.
(Hasnas 2013: 286, italics mine)
Markets exist because of a host of rules but two central rules for business are those concerning voluntary trade and property rights.
For an exchange to count as a business exchange it must be voluntary. We should not pretend there is an easy solution to the question of what counts as voluntary and what counts as coercive. Our purpose here is not to define the line between coercion and free choice. Rather, it is to identify that the existence of business depends on normative judgements, e.g., is the trading voluntary? Looking to law and to common language supports the claim that rules of voluntary trading are central in our discussions of what counts as business activities. For example, children are legally excluded from certain economic activities precisely because, prior to the age of reason, children may not be fully capable of giving voluntary consent. Similar concerns may apply to some adults. The condition of a person’s mental state or that individual’s external circumstances can affect the voluntary nature of trade. An undeveloped capacity to reason, emotional or psychological duress, or radically insufficient knowledge—for example, a situation in which one’s options are severely limited—may reduce the sense in which one may exercise a genuinely voluntary choice.
The other central rule, or set of rules, defining the context of a business exchange is property rights. Trading in the market is not simply trading possession of a good or service, it is also trading a set of rights to the good or service in question. Sometimes rights are completely transferred such that the recipient may do whatever she wants with the purchase. Other times the transfer of rights is not complete leaving the seller some rights (e.g., leases), or reserving those rights to a third party (e.g., homeowners’ associations). Either way, for a property right to be exchanged it must be legitimately possessed in the first place. No claim is made here about what the set of property rights must be, their origins, their philosophical justification, or whether they must be “absolute.” The distinction we make here follows that of the philosopher David Hume: that there are property rights is essential for the stability necessary for markets, what those specific property rights are is another question (1998 [1751]: Appendix. 3.10). Property rights make clear who has legitimate claim to various goods and services and this sets the stage for who is permitted to trade such goods and services.
One serious challenge to property rules concerns unpleasant or harmful effects on third parties, “negative externalities.” Pollution provides a classic instance of these externalities. However, purported secondary effects like crime, and even cultural shifts, can be the subject of discussion and debate on externalities and whether a specific trade, or the regime of trading, is entirely voluntary. Karl Marx and Friedrich Engels (1848) rue the effects of trading itself on society in general. In a different vein, Ronald Coase (1937b) discusses the problem of negative externalities and who should pay for them. While some negative externalities may be addressed through payments and clarification of property rights, it is not entirely clear that every effect of trade can be made voluntary. On the same note, it is not always the case that property rights can be clearly defined via philosophy or even determined by some empirical or historical facts of the matter—and yet a decision will still need to be made.
With both voluntary trades and property, the institutions of civil society will need to make decisions where facts and theories are incomplete. In business dealings, property rights will need to be settled, and exchanges will need to be judged voluntary or not. This is another problem for ethicists: these decisions will, in some instances, be difficult, even messy and, in other cases, seemingly morally arbitrary. As David Hume notes, when an appeal to public utility provides no clear answer to problems of property or trade,
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positive laws are often framed to supply its place, and direct the procedure of all courts of judicature. Where these too fail, as often happens, precedents are called for; and a former decision, though given itself without any sufficient reason, justly becomes a sufficient reason for a new decision. If direct laws and precedents be wanting, imperfect and indirect ones are brought in aid; and the controverted case is ranged under them by analogical reasonings and comparisons, and similitudes, and correspondencies, which are often more fanciful than real . . . and the preference given by the judge is often founded more on taste and imagination than on any solid argument.
(1998 [1751]: Appendix 3.10)
The rules of property rights and what constitutes a voluntary trade will therefore consist of a host of historically contingent factors. Such a conventional account of business faces at least two problems. First, the rules of the market have fuzzy boundaries and will not always yield a definite conclusion as to whether a certain activity is actually business or not. Second, this account relies on real-world, historically bound, processes and decisions that at least prima facie may appear morally arbitrary. Those who argue that determinations of rights and value distributions must be ethical “the whole way down” will not be satisfied with this account as it currently stands. To the extent that this warrants further argument and discovery we agree, but abandoning these rules entirely would also entail fundamentally changing the practice and concept of business.
Producing a good or service for trade
Within the rules of the market, attempting to profit by producing a good or service for trade is business.2 To execute an exchange the goods or services to be traded must be produced by each party to the transaction. How they go about producing and trading X is literally their business. A farmer who grows food just for herself is not trading and is not in business. If she gives away the food she is engaging in charity and if she is violating the rights of others in the process she is engaging in criminal activity. If she grows the food and then trades it with the intent to profit she is engaging in business.
Production of a good or service for trade is motivated by the desire to profit. The most basic formulation of this motivation is that each party to a trade expects to be better off as a result of the exchange. This point is captured by the historian Fernand Braudel:
the merchant’s problem remained the same: at the end of the day, the goods travelling towards him . . . had to fetch a price which would not only cover incidental expenses, purchasing price and transport costs, but also the profit the merchant hoped to obtain from the whole operation. If not, what was the point of risking one’s money and peace of mind?
(Braudel 1982: 169)
Luca Pacioli refined and advocated double-entry bookkeeping in Renaissance Europe because “the goal of every businessman who intends to be successful, is to make a lawful and reasonable profit” (1494: 4).3 Given the universal adoption of double-entry bookkeeping, Pacioli seems justified in his claim.
Business activity seeks profit. However, intent without action is empty. It is not the intent itself, but the activities required by this intent, that define business. First, making a profit requires doing something. Profit, and loss, are not activities of business. They are the outcomes of doing business: producing a good or service for trade (Kline 2006, 2009). Second, the intentional pursuit of profit requires keeping track of inputs, outputs, and to whom they are owed—the practice of accounting.
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Accounting is not a separate activity that is superimposed upon the activity of producing a good or service for trade. Accounting is constitutive of business, consisting of both tracking resources and recording who possesses the rights necessary for production and trade. These two aspects of accounting are what accounting historian Richard Mattessich (1989) identifies as the duality of accounting.
Tracking resources, the first part of the duality of accounting, is assessing how one’s resources are depleted through costs and augmented through revenues. Whatever specific actions businesses choose, these actions need to be measured as to the impact they have on either costs or revenues. The tracking of resources
expresses the one-to-one correspondence between an empirical event (such as a sale and purchase, or the transfer of goods and services from one department or process to another), on one side, and some representational scheme—be it a token accounting system of ancient Mesopotamia or a computerized matrix accounting system in the twentieth century—on the other side.
(Mattessich 1989: 78)
As Richard Mattessich reminds us, we should not conflate “accounting” with modern double-entry bookkeeping. Merchants were keeping track of accounts using “single-entry” methods well before double-entry was developed. Accounting even predates writing. Through extensive archeological analysis Denise Schmandt-Besserat (1996) argues that prehistoric humans were keeping track of accounts using three-dimensional objects, such as tiny square blocks and cones placed in containers, to record what we now call credits and debits. Even double-entry accounting has its origins in earlier Arabic and Hindu business practices of which Luca Pacioli himself was aware (Gleeson-White 2012). Accounting is constitutive of business across both times and cultures.
Resources are always limited and the business person needs to know how to allocate them. With the first part of the duality, tracking resources, accounting collects and reflects diffuse information in a form that is at the heart of making business decisions. Without this information there is simply no way to know whether business activity is generating a profit or a loss. Tracking revenues and costs is epistemically constitutive of doing business, but it is only half of what accounting does. Accounting also keeps track of who owns what and this is the second part of the duality of accounting.
“The second kind of duality seems not so much to arise out of a physical transfer, but of the fact that every asset belongs to somebody” (Mattessich 1989: 78). Rules of the market require respecting the rights of others e.g., property rights and contractual obligations. “[I]t was the need to keep a record of goods sold on credit . . . which inspired the first account books” (Braudel 1982: 572). Business activity requires not only knowing the relation between revenues and costs but knowing the relationships between buyers and sellers, thus respecting property rights by recording who is owed what. Creditors and debtors must be accounted for. Contractual obligations must be paid. It is in the settling of accounts that property rights are ultimately transferred which then makes possible the further voluntary trading of goods and services. Knowing who owns what is not an ancillary activity of business, it is central to producing a good or service for trade.
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Trading is a constitutive activity of business but trading is not the equivalent of business. To trade, potential trading partners must be sufficiently incentivized to produce and engage in voluntary trade. This expectation of gain requires knowledge of the costs of the good or service produced and how it relates to the expected gains from trade. One cannot record a gain, or a loss, if one does not know the initial baseline for judgment. If there is something called “business” that is distinct from “trading” one key difference is in tracking resources and their ownership i.e., accounting. Accounting as a constitutive activity of business is born out of the desire to gain, or at the very least not lose, from trade.
The intent to profit, and the distribution of profit, are contentious issues in business ethics, especially for stakeholder theorists. Based on the rules of property rights and voluntary trade, attempting to profit by producing a good or service for trade allows for the existence of a multitude of business organizations and practices. Such variation would include the possibility that in business organizations managers will have sole authority to determine resource allocation. It also includes the possibility that managers will have a fiduciary responsibility to maximize profits for the owners of the business.4 However, stakeholder theorists argue that these are morally impermissible ways to conduct, and organize, business. The next section will argue that stakeholder arguments actually go one step deeper. To be consistent with their own arguments, stakeholder theorists should conclude that any theory permitting fiduciary obligations solely between owners and managers, and the managerial authority to execute those duties, are in fact not theories of business at all. It would follow, then, that stakeholder arguments that reject fiduciary theories of business would also imply that the historical development of formal and informal institutions has allowed an aberration to occur in the form of firms that uphold fiduciary obligations. In both theory and practice stakeholder theory seeks to redefine the scope of what we identify as business organizations and activities. Stakeholder theory is thus not merely an argument that some business activities are currently unethical, it is ultimately an attempt to redefine the meaning of “business.”
Stakeholder theory, participation rights, and fair decision procedures
Stakeholder theory can be legitimately viewed and employed from multiple perspectives (Heath and Norman 2004). We cannot hope to address them all. Rather, the strategy here is to identify some elements of stakeholder theory that have a direct impact on the question, “What is business?” Since we have already identified the importance of rules and norms in defining business, a natural starting place is with normative stakeholder theory. Normative stakeholder theory has ontological as well as ethical implications for business activity.
One ontological implication follows from the denial of what has come to be called the “separation thesis.” The “separation thesis” is “the view that matters of economic value are somehow distinct from ethical values” (Harris and Freeman 2008: 541; see also Freeman et al. 2010). Freeman argues “The whole point of the stakeholder approach is to deny the Separation Thesis” (1994: 412). On the stakeholder view, neither the concept nor the activities of business are morally neutral. Ethics is a constitutive part of what business is. Arguing against the separation thesis also comports with the argument of this paper: The rules that define the activity of business are not ethically neutral. Ethics is part of what business is. “Business” is not a morally neutral term. Normative stakeholder theory, in conjunction with the rejection of the separation thesis, is not just a theory about what business should do, it is an argument of what “business” is, or at least, should be.
Normative stakeholder theory is a story about the nature of business and value creation, but there is not just one such “stakeholder story.” Rather stakeholder theory can employ different moral theories—normative cores—to adjudicate among the interests of different stakeholders (Freeman 1994: 413; 1997; Freeman et al. 2010: 213). Thus, stakeholder stories about business and value creation change depending on the normative core utilized. Stakeholder theory, though, is not neutral with regard to potential normative cores. The rules governing property rights and voluntary trade would be rejected as a normative core of stakeholder theory. After all, this normative core would yield the definition of business activity as producing a good or service for trade with the intent to profit. However, stakeholder theorists typically oppose this conception of business. There are at least two reasons why and both have implications for what constitutes business: profit distribution and managerial authority.
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John Hasnas identifies two substantive normative implications of stakeholder theory.
Managers of an organization do not have an exclusive fiduciary duty to any one stakeholder group, but rather, are obligated to ensure that the value created by the organization is distributed among all normative stakeholders and that all normative stakeholders have input into the managerial decisions that determine how the organization attempts to create value.
(2013: 52)
Jeffrey Moriarty (2012) likewise identifies both a general distributive and a separate, but connected, procedural element in stakeholder theory. These elements cut across normative stakeholder theories regardless of the specific normative core. They also function as constraints on what can be in the normative core and thus as constraints on what stories count as business. We shall examine each in turn.
Procedure and stakeholder voice5
Stakeholder theory argues it is morally unacceptable for managers to make unilateral decisions that affect others in an enterprise that depends upon joint cooperation (Gould 2002: 13). The right of exit is morally insufficient. Stakeholders must have a substantive voice in business activities that affect them. In stakeholder theory voluntary contracts cannot be the “last word” in defining managerial authority. Some set of basic rights must carry over into the activities of business and delineate which voluntary agreements count as business and which do not. John Rawls identifies a generally accepted list of these basic rights in A Theory of Justice (1971).
According to Rawls, the first basic right is that “each person is to have an equal right to the most extensive basic liberty compatible with a similar liberty for others” (1971: 60). While this includes a right to private property, it also includes rights like voting and free speech. And while Rawls (1993) rejects the application of his theory to business, Moriarty (2005) counters that for purposes of justice the difference between business and the state is one of degree not kind, so that these basic liberties are applicable within business. Additionally, while some theorists directly refer to Rawls to make this same point, others do not. For example, Carol Gould argues that there is a “prima facie requirement of democratic participation” in business (2002: 13). Bruce Barry (2007) argues that free speech should be protected within a business, even when that speech is critical of the very same business enterprise. Stakeholders deserve a voice in business decisions because of this background of participatory rights. In stakeholder theory, political decision making is constitutive of business. The normative rules of the polity at large, not just the market, define what constitutes business activity. Business becomes a political arena where doing business is doing politics.
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Fair distribution versus negotiation
Concomitantly with participation rights in stakeholder theory comes the idea that a distribution of the value business creates must be “fair.” Freeman and Evan (1990) and Freeman (1994; 1997) use a Rawlsian “veil of ignorance” argument to establish what would constitute a fair contract. Child and Marcoux (1999) argue that Freeman, and Freeman and Evan, fail to appropriately construct a relevant “veil of ignorance” argument for business and that their arguments fail internally. But if veil of ignorance arguments can still be generally applied to business, then specific arguments against Freeman and Evan leave the door open for other possible formulations and this is exactly what we see in the literature (Cohen 2010; Evans and Evans 2014).
Veil of ignorance arguments are a direct replacement, if not condemnation, of the very real practice of negotiation. Negotiation is a multivariable problem involving the preferences of both agents, knowledge about competing agents, information about relevant supply and demand, substitution possibilities, and a host of persuasive skills. The information, resources, and skills brought to the negotiating table will be asymmetrical and conducted under incomplete information. Central to a veil-of-ignorance strategy is removing all such specific knowledge of the decision maker’s position in the world, leaving just a basic knowledge of social science and the basic goods of human life (Evans and Evans 2014; Freeman 1994; Rawls 1971). Since all specific knowledge is removed from the bargainers, they also have the same preference orderings. A multiple party bargaining situation is reduced to a single ideal agent parametrically deciding which rules secure those outcomes consonant with a purportedly rational preference ordering and a stipulated level of risk aversion. All human communication is removed from the process which is, in fact, no longer a bargaining problem.
The art of negotiating lays bare the communicative and interactive nature of actual business transactions. Bargaining requires the use of strategic rationality (Elster 1985), whereby agents realize how their own actions affect the actions of others. In bargaining situations, outcomes are determined by the joint action of all parties. In these situations agents must learn the rules of the game, the various possible outcomes, their own valuation of these outcomes, and the most likely preferences of the other bargainer in relation to these outcomes. In this process communication between contracting parties has a real effect.6 Decision making behind the veil wipes this all away. Interestingly enough, standard game theory representations do so as well since they assume that both parties value the objective possible outcomes equally and that communication does not matter; this however is just an assumption akin to assuming that the firm’s cost of discovering the market price is zero. However, in actual negotiations, getting the best deal means discovering the minimum my interlocutor will accept. This will depend on factors such as how wealthy or poor the person is, her related alternative options, and how well she negotiates. Information asymmetries are unavoidable since agents only have limited and dispersed knowledge regarding any economic problem they face (Hayek 1945). It is precisely the importance of these information and preference asymmetries in negotiations that unsettle many ethicists, and it is thus the fundamental nature of forming voluntary agreements that stakeholder theory and the doctrine of fair contracts attempts to replace. Choosing from behind a veil of ignorance is not, therefore, business activity.
Stakeholder theory correctly identifies that what business is and does is not ethically neutral. Furthermore, stakeholder theory argues against traditional managerial authority and an exclusive fiduciary duty of management to maximize profits for owners. Attempting to profit by producing a good or service for trade allows for, but does not dictate, such an organizational structure. Stakeholder theory, then, is in opposition to the definition of business advanced in this chapter. Furthermore, to the extent that rational and fair distribution of profits is advocated, stakeholder theory pits itself against the practice of business as it has historically developed. What remains is not so much a theory of business as a transformation of business into a form of ideal political theory. Freeman is correct to state that the current organization and practice of business is not meant to survive the implementation of normative stakeholder theory (Freeman 1994: 415, 418.). In fact, it is not clear that “business” is meant to survive at all.
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Concluding remarks
Business ethics is about both business and ethics. Just as there are disagreements about what ethics is and requires, so too is there disagreement about what business is and requires. Focusing solely on the corporation is too narrow. Alternatively, transaction cost theories of the firm are too broad in scope, explaining why organizations exist but not telling us what business is. It is the activities of organizations and individuals that really define what business is. What counts as business activity, though, is at least in part defined by two institutional rules of the market: property rights and voluntary trade. Within this institutional framework, attempting to profit by producing a good or service for trade answers the question “What is business?” Business is the activity of attempting to profitably solve problems. Within the proper institutional framework, the activities of production, voluntary trade, accounting, and negotiation are constitutive elements of the attempt to make a profit from these solutions (be they in the form of a good or a service). The activity of seeking profitable solutions through trade will give rise to a multitude of business organizations including, but not limited to, those where residual earnings go to the owners and managers have a fiduciary obligation to maximize profits.
R. Edward Freeman claims that we need to (re)conceptualize this “value-creation” process (1994). In fact, the phrase “value-creation” is part of this reconceptualization of “business.” While stakeholder theory continues to use the word “business” it is difficult to see how those versions that argue for democratic decision making and “rational” profit distribution resemble what has historically evolved as business. Instead, these versions of stakeholder theory posit a rationalist ideal conception of “value creation” to replace the historical and conventional practice of business as it has developed in the world.
Many would herald such a change based on a belief that a liberal institutional framework and the activities it permits are morally deficient. We should not forget, though, that rules concerning property rights and voluntary trade have evolved over the centuries in part to mediate ethical disputes. Furthermore, the activities of business require the exercise of a host of virtues we have not been able to examine here. Assuredly there are ethical critiques of the current institutional framework of business and not every business action is virtuous. Just because something has evolved the way it has does not absolve it from ethical examination and refinement. Still, arguing for a reconceptualization of business implies that we truly understand what business is in the first place. Given the complexity of law, history, and the massive diversity of actual business activities, claims to such a complete understanding should be regarded skeptically. On-going scholarship and research suggests our understanding of business is far from complete. Rather than reconceptualizing business, we would do better to deepen our understanding of what it is in the first place.
Essential readings
Essential works on transaction cost theory include Ronald Coase, “The Nature of the Firm” (1937a), Oliver Williamson, Markets and Hierarchies: A Study in the Economics of Internal Organization (1975), and Michael Jensen and William Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” (1976). Essential works on business as an activity include William Kline “Business Ethics from the Internal Point of View” (2006), and Alexei Marcoux “The Concept of Business in Business Ethics” (2006). Essential works on stakeholder theory include R. Edward Freeman et al. Stakeholder Theory: The State of the Art (2010), and John Hasnas, “Whither Stakeholder Theory? A Guide for the Perplexed Revisited” (2013).
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For further reading in this volume on the firm as a set of contracts, see Chapter 6, Social contract theories. On agency theory and the firm, see Chapter 17, The contribution of economics to business. On motivation in business, see Chapter 21, Regulation, rent seeking, and business ethics. For a discussion of exchange and profit, see Chapter 7, Can profit seekers be virtuous? On the status and justifications of property rights, see Chapter 18, Property and business. For an account of accounting as a profession, see Chapter 31, The accounting profession, the public interest, and human rights.
Notes
1 The counter argument would be that under a system of state-owned enterprises, e.g., socialism, business would be an institution of the state. This counterpoint hinges on the extent to which business can exist without markets. The historic argument on this point is the economic calculation debate (Lavoie 1985). What we see today, though, is many state-owned enterprises firmly operating within larger markets. These state enterprises may be hybrids of some sort, if you will, but still subject to the observation at the beginning of this section: Any examination of even state-owned “business” is incomplete without understanding the rules of the market. It makes no difference to the argument at hand whether or not states create markets. Understanding business still requires understanding that market institutions set the parameters of what is defined as business activity.
2 “Produce” here is meant quite broadly as in “producing a witness.” For our purposes, it is not a synonym for manufacturing.
3 Luca Pacioli (144–1517) was a Venetian mathematician who wrote Particularis De Computis Et Scripturis (1494), which both refined and advocated double-entry bookkeeping. It is because of Pacioli’s work that double-entry bookkeeping was adopted across Western Europe, replacing earlier forms of single-entry bookkeeping.
4 Friedman (1970) is perhaps the most famous argument in favor of management’s fiduciary obligation to owners.
5 A.O. Hirschman defines “voice” quite broadly as “any attempt at all to change, rather than to escape from, an objectionable state of affairs” (1970: 30). This chapter explores a subset of voice options dealing with direct stakeholder participation in managerial decisions.
6 As an example of how important communicating is to negotiation, and the very real impact it can have, see Babcock and Laschever (2007).
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