The Grey Areas of Firm Behavior: An Economic Perspective

Socio-Economic Review, Vol. 12 (January 2014), pp. 167-176.

16 Pages Posted: 21 Jun 2017

See all articles by Jonathan M. Karpoff

Jonathan M. Karpoff

University of Washington - Michael G. Foster School of Business

Date Written: October 22, 2013

Abstract

Firms do some things that are profitable, and some things that contribute to the greater good. Adam Smith’s Invisible Hand is the idea that profitable activities and socially desirable activities are frequently one and the same. It is popular to scoff at the Invisible Hand (e.g., see Hardin, 1968), but Smith’s articulation of it remains one of the most important discoveries in the history of social science. It explains not just how we get our daily bread (which was one of Smith’s examples) and the iPhone (which might be his example today), but more fundamentally, how wealth is created and how humankind has escaped the penury of autarky. Not everything that is profitable for businesses, however, is good for the rest of us. Firms can profit by polluting, defrauding customers or investors, bribing government officials, reneging on contracts with employees, or holding up payments to suppliers. Moreover, there are many socially beneficial things that firms do not do because they are not profitable, such as investing in basic research, giving more to charity, or adhering to stricter environmental guidelines than required. Stated differently, profitability and social desirability are not perfectly correlated. Activities in which profitability and social desirability do not coincide are the grey areas of business behavior. These are the activities that can, and indeed must, be guided by forces other than their apparent profitability to firms.

This paper examines these grey areas and the inducements firms have to exploit or avoid them. Recent research offers reasons for both hope and concern. On the hopeful side, it turns out that the Invisible Hand has a longer reach than we might first anticipate, as firms and managers face powerful private inducements to avoid many socially harmful activities such as fraud and misrepresentation. This implies that many “grey activities” are really not so grey, in the sense that firms that act badly end up hurting their bottom lines as well. Of concern, however, are findings that such private market inducements are weak for some types of activities, including environmental harms and bribery. There remain strong financial incentives to pollute or bribe, implying that these harmful activities can be controlled only through moral suasion or legal enforcement. A further concern is the widespread use of the political process to shift costs onto others. This encourages firms to invest resources to make profitable some types of socially harmful activities that they otherwise would not pursue.

Keywords: Invisible hand, externalities, social welfare

JEL Classification: L20, L51, D23, I31

Suggested Citation

Karpoff, Jonathan M., The Grey Areas of Firm Behavior: An Economic Perspective (October 22, 2013). Socio-Economic Review, Vol. 12 (January 2014), pp. 167-176.. Available at SSRN: https://ssrn.com/abstract=2990046

Jonathan M. Karpoff (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Box 353226
Seattle, WA 98195-3200
United States
206-685-4954 (Phone)
206-221-6856 (Fax)

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