Monday, April 30, 2007

Ideological Purity or Intellectual Muddle

I’ve been doing little preparations for my session at the upcoming Faculty Summer Institute. One of my ideas is for instructors to make use of multimedia content that is freely available online and incorporate that into their own presentations. Indeed, the idea is to do some analysis of that content and then deliver the result in a dialogic fashion.

On Friday I saw an item in Ray Schroeder’s Techno-News blog that talked about some good sources for such content, and At the latter site the content can be accessed by subject and after some quick browsing in Business and Economics I found this gem of a presentation/debate on “Business Ethics.”

In the College of Business here we’re talking about how to introduce such ideas to students in a way that is meaningful to them. This video might be a good way to do that. It features Milton Friedman and if the students have never seen him argue before that would be worthwhile in its own right. I watched/listened to the entire thing (after viewing the video long enough to understand who is who in the debate, the audio track is sufficient and one can multi-process that way and still get the sense of the argument). Of course Friedman was a great debater and one of the skills he used to good effect in this session was to argue from a theoretical basis, in this case of what Business leaders should do when they are behaving ethically. This argument was first articulated in the article I’ve got linked in the right sidebar under Pieces I Enjoyed Reading where title begins, The Social Responsibility of Business… (Incidentally, since during the video Friedman mentions the royalties he received from reprint of this article, that the Libertarian Student Group at Colorado posted this piece to the Internet is quite possibly a copyright violation, though I should note that the copy in the Times Archive available via Times Select is not as readable as the version on the Colorado site.)

Friedman, who for me represents the Ideological Purity side of the argument, gets the better of Kirk Hanson, who at least in some of his remarks seems to argue for the other side. And while Friedman really doesn’t need the help of others to make his case, in this debate he gets some help from David Brady, who applauds Friedman’s approach because it produces “an answer” in a systematic way and who offers a critique of Friedman’s argument only in the case of a multinational dealing in a Third World country, where there is no effective government to enforce institutions aimed at providing for the common weal and so where one of the fundamental assumptions in Friedman’s argument about the role of government doesn’t hold. Otherwise, Brady is in the Friedman camp. And that makes this a two against one argument, with Bowen McCoy serving more as a moderator than as a participant in the debate.

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In this post I want to try to show several things. First, I can really like something I watch or read without agreeing with it. I like hearing Milton Friedman because he gives a clear articulation of his views and does that well. But I rarely find myself agreeing with him. Here I’m going to come down against Friedman and for the side of Intellectual Muddle, because I think things are harder and more complex than he argues. Second, a piece of material like this video can be viewed as a gateway into a larger discussion rather than as an endpoint to be absorbed. So I’m going to provide some hints at where that larger discussion might head. Third, while this post may seem to be coming from left field, I want to show how it ties into other ideas that have made it into my blog, particularly on the usefulness of economics (or lack thereof) as a guide for decision making and on whether we should be open or closed in pursuit of our own learning.

Below is an annotated list of the issues.

1. Decision making is fundamentally seat of the pants. The economic theory of choice is first presented under certainty where it is logically correct and rarely disputed. It is then extended to a situation of risk, where the loss frequencies are objectively determined, and from this model one can derive a demand for insurance. The theory has been critiqued, most notably by Kahneman and Tversky, because it seems to fall victim of “framing problems.” But there is a more profound issue when the question is uncertainty rather than risk (see part B in this discussion of Knightian risk and Uncertainty which makes it appear that uncertainty is the rule not the exception) and the problem is the inability to separate out the subjective probability distribution of the decision maker from that person’s predisposition toward the choice. In the video David Brady makes it seem that Friedman’s approach requires only that a careful scrutiny be done of all the relevant information to enable the appropriate cost-benefit analysis. However, a little reflection about the big issue of our times, the War in Iraq, should make it clear that predisposition affects the way in which evidence is weighed.

One can mythologize about the decision maker as an independent and skeptical scientist who objectively ways evidence and then makes a choice. Under this myth, if we were equally informed we’d come to the same conclusion and the decision maker qua scientist conveys this notion of replicability. This is what David Brady seems to imply. The problem is that since the decision maker cares about the outcome the detachment in the mythical view is often not there and since the decision is one-and-done there is no discipline device to bring about that detachment. We bring bias into the decision making but in a way where that is only revealed after the fact. We are frequently not aware of our own bias at the time the choice is made.

Further, there frequently is not enough information to rationalize the choice, but a choice needs to be made nonetheless. So we take a stab at it. I often felt that was what I was doing when I made allocation decisions on behalf of the campus in my previous job.

2. The standard agency problem is present. This one even Friedman himself would agree with though he might not agree with all the ways this issue is articulated, such as in this abstract. The standard theory of the firm is best articulated with a single owner/proprietor who makes all the decisions. There is no agency problem in this case. In large corporations, however, there is a separation between ownership and control. A CEO’s desire to take care of #1 may not be in the interest of shareholders. Paul Krugman’s column in today’s NY Times suggests such an agency problem in that high profit firms don’t seem to be investing in capital to increase future productivity. Friedman ignores the agency problem in his 1970 piece, although to be fair to him nobody has offered up that having firms act in a socially responsible way is a solution to the agency problem (as opposed to being a good end in itself) and hence for this argument perhaps the agency problem can be ignored. But I want to bring it back to emphasize that we operate in a world of the Second Best, and hence Friedman’s implicit reliance on the First Fundamental Welfare Theorem may be misplaced.

3. Trust relationships matter. In my own job I find collegiality to be a hugely important value, something I try hard to promote and preserve. Indeed at the Learning Technology Leadership Institute to be held at Madison Wisconsin this July, Larry Ragan and I are leading a session on how to build successful relationships. In principle, one can treat trust relationships as non-tangible capital and then give those relationships some lines on the corporate balance sheet in the same way that plant and equipment are entered there. In practice, assessing the valuation of trust relationships is an art, not a science, and there is likely to be a high degree of imprecision in any such assessment.

There is a strong ethical component in the decision to honor or break a trust and anyone engaged in making such a decision is likely to think of it in personal terms. One can try to recast the choice in purely financial terms, in which case the analog is with a collateralized loan where repaying the loan (honoring the trust) makes sense as long as the value of the collateral exceeds the value of the loan, but not otherwise.

Consider the case of employee pension plans, particularly of the defined benefit variety. We know that in cases where those plans have been under funded, such as with the airlines, the bankruptcy laws have been used strategically either to eliminate the benefits to senior employees entirely or to substantially reduce the benefits from what was promised originally – in either case an example of breaking the trust. We know that in other cases where the pension plans were well funded that the company became attractive for takeover so that the pension plan could be raided and then the rest of the company’s assets gutted.

From the perspective of the CEO of such a company the decision to declare bankruptcy or not in the first instance and the decision to accept the raider’s bid or fight off the takeover in the second instance have ethical aspects. And my point here is that if the CEO is looking for wisdom to make a sound decision from an ethical perspective, then there will be little help from Friedman’s admonition to maximize profits. There may be cases where the company is doing so poorly that declaring bankruptcy is not a choice among other alternatives but the only possibility. There may be other cases where the company is doing so well and has such a bright future that selling it off to go out of business doesn’t make any sense. The ethical dimension enters in the vast gray area that lies between those two extremes. And now we’re back in the domain of my point 1. Prior disposition matters. For someone who takes stock in the statement, “My word is my bond,” declaring bankruptcy is a breach of trust.

For others who prefer to look at the pension issue purely in financial terms, there is likely a lower implicit valuation of the benefit from maintaining the trust and hence a chance that they’ll argue for declaring bankruptcy. Is this unethical? Let me turn to the 4th point and then come back to that question.

4. The decision to openly disclose is not straightforward. In describing fairness, one frequently characterizes a situation where the rules of the game are well articulated up front, everyone acknowledges they understand the rules, and then the choice to play the game is opt in. In the last paragraph of Friedman’s essay he writes:

But the doctrine of "social responsibility" taken seriously would extend the scope of the political mechanism to every human activity. It does not differ in philosophy from the most explicitly collectivist doctrine. It differs only by professing to believe that collectivist ends can be attained without collectivist means. That is why, in my book Capitalism and Freedom, I have called it a "fundamentally subversive doctrine" in a free society, and have said that in such a society, "there is one and only one social responsibility of business–to use it 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."
Applying Friedman’s notion to the question at hand here, does the requirement to be in open and free competition without deception or fraud require the firm to disclose in advance to its employees under what circumstances it will declare bankruptcy? Ask yourself whether it is possible for a firm to do that without the message itself being interpreted as signaling the likelihood that the firm will need to incur bankruptcy because it is not performing well. How else could an employee interpret such a message other than as a pessimistic forecast of the firm’s fortune? If indeed the firm’s future seems rosy to the CEO, wouldn’t it be misleading and irresponsible to create worry in the employees by sending such a pessimistic message?

Now we can return to the question at the end of section 3. I believe there is no credible way for a firm to communicate with its employees well in advance about the circumstances under which it will declare bankruptcy. If I’m correct in that then employees who opt into the pension plan do so under a fundamental uncertainty about the default risk they face. Therefore, breaking the trust in a circumstance where the CEO retains discretion to do otherwise would be unethical (it would be unfair to the employees) although it might very well be profit maximizing. Moreover, in such a circumstance there may be no way to tell for sure whether it is or it isn’t.

* * * * *

I’ve focused on the employer-employee relationship in making my arguments. Do these arguments apply to the firm-customer relationship in a straightforward way, for example with respect to the health and safety of the products produced or even with respect to quality and reliability of the products? I think so. The same conditions regarding opt in are there, though one might want to distinguish between good and reliable customers, on the one hand, and occasional customers on the other. There is a trust relationship with the former where there might not be with the latter.

Does the argument apply as well to the firm-society relationship? Here my instincts are more in line with Friedman’s argument. There may be win-win things a firm can do (provide for daycare near the firm, reduce crime in the vicinity, etc.) that can be justified by profit maximization alone. There is likely uncertainty on this front as well and so management predisposition will matter, but once accounting for that it is hard to make a case for philanthropic gestures that don’t otherwise seem to add to the bottom line. The CEO is not Robin Hood. Nonetheless, I would like to hear somebody argue for the opposite as forcibly as Friedman argues for his view. That would help me to see if I need to modify the case I’ve just made.

Let me conclude with the following observation. Bowen McCoy starts the video talking about his dual roles as a participant (and teacher) in his church and as a businessman and how the one informs his actions while doing the other. I believe that most of us don’t make this cross-over very well if at all. For many of our students they must feel with respect to school that they operate entirely outside a world where ethical considerations apply. We know that many of them have admitted to cheating on occasion, which makes sense only if they see it as a victimless crime, like driving over the speed limit. If we are to teach with this video and Friedman’s essay, and offer lessons on Business Ethics that have meaning, somehow the students need to make connections to their own lives. That will be the hard part with the instruction.

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