Ethical Theory of the Firm
Abstract:Finance traditionally has a typical neoclassical character. The strong dependence of this approach on rational economic man and its obvious restrictions concerning realistic human behavior led to the emergence of alternative theoretical concepts. Well-known examples are quasirational economics, institutional economics and behavioral finance. In this chapter we show that the shareholders paradigm is an outdated concept in the modern stage of market capitalism. The traditional theory of the firm is too restrictive to incorporate ethical values into the financial framework.
In the property rights model it is the shareholder that holds the residual risk and therefore the residual profit. The company is considered a set of direct-investment projects that converts inputs into outputs. In this view a company is not a system of cooperating persons but a contracting institute that produces cash flow. From this perspective no social responsibility is involved. This typical neoclassical approach is justified by selecting the shareholders as the optimal stakeholders in order to reduce the agency cost. This line of argument denies an explicit relationship between social cohesion and operational efficiency.
In the ‘finance and ethics’ approach the neoclassical paradigm is replaced by a broader economic view. Care for the environment and the (social) health of employees are necessarily juxtaposed with competition and profitability as priorities. Competition encourages operational efficiency, but at the same time it is too limited as an allocation mechanism. The problem with this type of approach is that it replaces the strict quantifiable approach by a more qualitative one. It looks less structured than the modern mathematical approach used in financial theory. But, like the well-known ‘invisible hand’ of Adam Smith, there could also be an ‘invisible morality’ in the functioning of the market.
Document Type: Research Article
Publication date: January 1, 2007