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tHE ECONOMICS OF ETHICS: A NEW PERSPECTIVE ON AGENCY THEORY*

ERlCNOREEN Department of Accounting, University of Washington

Abstract Agency theory provides a series of instructive parables concerning the systems consequences of unreser-vedly opportunistic behavior. Due to a mutual lack oftrust, some otherwise mutually beneficial exchanges do not take place. And, even when exchanges do take place, there arc dead-weight losses clue to monitoring costs and inefficient risk sharing. Therefore, in ex ante terms, everyone may be better off if they mutually agree to restrain their opportunistic behavior. Unfortunately, by its very nature, opportunistic behavior is not readily observed. Thus, an agreement (i.e. ethical code) to abstain from opportunistic behavior cannot be effectively enforced by external rewards or sanctions; instead, the sanctions for unethical behavior must be internalized. Hopefully, this article will stimulate ideas for incorporating ethics in discussions of ac-co

360 ERIC NOREEN

nature of the contracts that are observed. 3 Indeed, agency theory has been successfully used to explain common features of contracts such as lending agreements.4 Second, agency theory can be used to provide a series of instruc-tive parables that illustrate the adverse conse-quences on social and economic systems of unconstrained opportunistic behavior. As Arrow (1968, 1974, 1975), Becker (1976), Harsanyi (1976) Kurz (1977), Hirshleifer (1977) and others have pointed out, certain varieties of ethical behavior are essential for the efficient functioning of many markets. For example, Arrow ( 1975, p. 15) states:

It can be argued that the presence of what are in a slightly old-fashioned terminology called virtues in fact plays a significant role in the operation of the economic system . . . [T]he process of exchange requires or at least is greatly facilitated by the presence of several of these vir-tues (not only truth, but also trust, loyalty, and justice in future dealings).

McKean ( 1975, pp. 30-31).

Unwritten agreements and trust (that is, confidence in each other's voluntary compliance) ... [play] pervasive roles in business and social intercourse. Written con-tracts in business hit only the highspots of agreements; like the bulk of the iceberg, an enormous portion of such mutual understandings is unseen ... Many small, yet in the aggregate highly significant, instances of trust exist ... without the pressure of competition or the threat of a lawsuit.

Thus, certain forms of what might be called ethical behavior (e.g. truthfulness, justice in fu-ture dealings, voluntary compliance, etc.) are necessary for efficient functioning of the economy. However, ethics is concerned with

much more than the efficiency of social and economic systems. To narrow the scope of the discussion in this paper, it would be useful to classify ethical behavior as either altruistic or ul-timately utilitarian in motivation.

Altruistic behavior is motivated either by a fundamental concern for the welfare of others or by the desire to feel good by helping others. Utilitarian ethical behavior, on the other hand, has to do with voluntary compliance with rules that are, in some sense, in the individual's own self-interest. An individual obeys utilitarian ethi-cal rules in the expectation that others will also obey the rules and that, as a consequence, sys-tems function more efficiently and there is more to be consumed by everyone.

This paper is concerned with utilitarian ethi-cal behavior. Altruistic behavior is real, is im-portant and probably should be encouraged. 5 However, the purpose of this paper is to provide a reminder that there are sound economic rea-sons for at least some forms of ethical (i.e. self-constrained) behavior. Specifically, the agency theory model, which assumes unconstrained op-portunism, can be used to graphically illustrate the adverse consequences of unethical behavior on the functioning of markets.

OPPORTUNISM AND THE FUNCTIONING OF MARKETS

Providing that all exchanges between people are voluntary and marketed-mediated, all infor-mation is public, and there are no costs to trans-acting, the allocation of resources that results from market trading is pareto optimal (Debreu,

1 Even if everyone did act ethically, agency theory would still be useful in understanding contracts if parties to a contract suspected (incorrectly) that the other parties to the contract might not act ethically.

4 However, the desire of the principal to protect himself from a possibly incompetent agent is an alternative explanation for at least some of the features found in agency contracts.

'Schelliing (1968) points out that if people are not very adept in choosing actions that are in their own best interests, it is unlikely that they will be more successli.Il in choosing actions that will be in the best interests of others. To illustrate that al-truism does not resolve all social dilemmas, Schelling presents an "altruists dilemma" that is the mirror image of the oppor-tunist's "prisoner's dilemma".

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1959).6 That is, any departure from the alloca-tion of resources obtained as a result of market transactions would necessarily make someone worse off.

Unfortunately, not all exchanges between people are voluntary and mediated by the mar-ket, there are costs to transacting, and not all in-formation is public. These real-world condi-tions, together with unconstrained oppor-tunism, can lead to market pathologies. Akerlof ( 1970) describes one of these pathologies in "The Market for Lemons". Suppose that there are random manufacturing defects in cars which substantially affect operating costs and which are difficult to detect through inspection. Through use, however, an owner can discover his own car's defects- or at least the impact of those defects on operating costs. Consider how the market for used cars would operate. Poten-tial buyers would discount the price offered for used cars to reflect the expected excess operat-ing costs from manufacturing defects. Suppose the price that would be offered for a defect-free used car would be $5000 and that the average, across all cars, of the net present value of excess operating costs from defects is $2000. Since the buyers cannot tell whether a car is free from de-fects or not, it would seem that the price offered for all cars would be $3000.

However, at this price, owners of defect-free cars will tend to stay out of the used car market. Indeed, there will be a general tendency for owners who have cars with defect costs of less than $2000 to stay out of the market and there will be a tendency tor owners who have cars with defect costs exceeding $2000 to rush into

the used car market. (In the insurance industry this is termed the "adverse selection" problem.) Thus, the price of $3000 for a used car cannot be sustaining. Eventually, purchasers will discover that their anticipations were incorrect. In this situation, the only price that will sustain an equilibrium is a price that assumes that only the worst cars will be brought to the market by their owners. If the net present value of excess operat-ing costs can exceed $5000 for as many cars as are demanded in the used car market, then the market would collapse altogether and no used cars would be sold.

Note that everyone suffers from this adverse selection problem. Those who would like to sell their cars cannot, and those who would like to buy a used car are deterred by the opportunism of sellers.

Various measures can be employed to get around this problem. Mechanics can be hired to examine cars prior to purchase or they can be operated by a neutral third party long enough to estimate their excess operating costs. But these are costly and imperfect solutions. The simplest solution would be for sellers to truthfully reveal the excess operating costs of their cars. But how can this solution in which all sellers tell the truth be enforced? This central problem will be consi-dered later in the paper.

This example illustrates that in the presence of asymmetric information and unconstrained opportunism, adverse selection can lead to the collapse of markets and/or to costly investiga-tion. In general, markets may have problems functioning in situations where there is private information that is difficult to verify.7 And the

6 Pareto optimality is admittedly a weak criterion and in particular it is silent concerning the relative desirability of alterna-tive distributions of initial resources in the economy. Thus, an economy in which there are perfect and complete markets and in which only one person is endowed with all the resources yields a pareto optimal market solution as does a similar economy in which endowments are spread more or less evenly across individuals. 7 Arrow ( 1975, pp. 20-22) provides an intriguing example of a peculiar form of adverse selection. Hepatitis in blood trans-

fusions from donors who have had the disease is a serious health problem that leads to one death out of every 150 patients over the age of 40 who receive a transfi1sion. Hepatitis can not be reliably detected in blood samples, so the only recourse is to rely on donors to report whether or not they have had hepatitis. In one study, one half of patients undergoing cardiac surgery were given blood obtained from paid donors while the other half were given blood obtained by voluntary donors. The post-transfusion rate of hepatitis in the group supplied by paid donors was 53%, while there where no cases of hepatitis in the group supplied by voluntary donors. "A voluntary donor system is ... self-enforcing. Anyone whose motive for giving is to help others, but who suffers from hepatitus and is aware of the implications of this, will of course refrain from giving. On the other hand, a commercial blood donor, especially one driven by poverty, has every incentive to conceal the truth."

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person who has the private information may lose just as much or more than the person who does not.8

Jensen & Meckling (1976) deal with the im-plications of unconstrained opportunism for the organization and financing of business enter-prises. They discuss the situation in which an en-trepreneur raises funds by selling shares in the firm. The entrepreneur sells off most of the firm, retaining a fraction of the outstanding shares and continues as manager. The incentives for the manager to work and to consume perquisites at the firm's expense change as a result of going public. The manager gets the same benefits from avoiding work and from consuming perquisites (such as a corporate jet) whether the firm is wholly owned or only partially owned by the manager. However, the manager bears only the fraction of the cost corresponding to his share in the firm. Consequently, an opportunistic man-ager would work less and consume more costly perquisites after going public. If potential shareholders believe they are dealing with an opportunistic manager they will pay less for the firm than they otherwise would. Jensen & Meck-ling implicitly assume potential investors are willing to pay some positive price for a share in the firm. But, it may be impossible for the man-ager to sell shares in the firm in the face of this conflict of interests. The market for new issues of stock is subject to the same adverse selection problems as the market for used cars. If oppor-tunities and proclivities for consumption of per-quisites differ across firms and these differences are difficult for an outsider to accurately esti-mate, then there is a potential for adverse selec-tion. The price offered by investors will reflect the worst possible cases, rather than the average consumption of perquisites in the economy. If opportunities for consumption of perquisites are ample, the market for new issues may col-lapse altogether. This is in no one's interest, least of all the entrepreneur/manager's.

If the entrepreneur could guarantee that he would not increase his consumption of perquis-

ites, everyone could be made better off. The value of the shares the entrepreneur sells should go up by an amount equal to the expected cost of the perquisites he would have consumed. The entrepreneur could then use the extra cash to buy whatever he wants. His consumption set would not have to be limited to items with at least some ostensible business rationale. The problem is that it is difficult to verify this guaran-tee. Absentee shareholders cannot costlessly monitor the manager's use of the corporate jet. They would find it unfeasible, even at very high cost, to monitor the amount of effort the man-ager puts into his job: Clever contracts can be devised that reduce conflicts of interests. Gener-ally, however, these solutions are costly al).d im-perfect and they result in inefficient risk-sharing. The best solution, which is costless, is for the manager to truthfully report his effort and his consumption of perquisites. But, once again, the central problem is how to enforce truthful re-porting.

Jensen & Meckling point out other potential conflicts of interest that can arise within a firm. Shareholders have many opportunities to ex-propriate the wealth of bondholders. To take an extreme case, shareholders can pay out all of the assets of the firm as dividend just before a bond matures, leaving the bondholders with nothing. There are less blatant ways in which sharehol-ders can be made better off at the expense of bondholders. Shareholders can "bet the firm" on a risky project. If the project turns out well, shareholders get the benefits. If the project turns out poorly, bondholders are left holding the empty bag.

Bondholders protect themselves with coven-ants, monitoring and a higher interest rate, but protection is imperfect and costly. It is not obvi-ous that, in the presence of truly unscrupulous managers and shareholders, there would be any-one willing to extend credit. Again, this situation is not in anyone's interest - least of all the shareholders who would like to be able to raise capital without diluting their equity interests.

8 The problem is not solved by revealing private information if there are incentives to distort the information and it is costly to verify.

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While not a perfect solution, much of the bond-holder/shareholder conflict of interests could be ameliorated if the manager (believably) pledges to maximize the combined value of shares and bonds.

There are other obvious, and not-so-obvious free market pathologies as well. One problem is that not all exchanges between people are vol-untary - for example, burglary. The obvious cost to burglary is loss of possessions. Perhaps the greater loss is the economic and psycholog-ical cost of turning homes into fortresses. One strategy is to expend resources to catch and punish people who initiate undesired involun-tary exchanges with other people, but the best solution is for everyone to agree not to engage in such undesirable behaviors.

THE ROLE OF ETHICS

It is evident that compliance with certain rules promotes efficiency; that is, the "economic pie" is larger when certain behavioral rules are followed than when they are not followed. Hir-shleifer ( 1977, p. 28) states with beautiful simplicity that "altruism economizes on the costs of policing and enforcing agreements". Agency theory suggests some of the rules that could be fruitfully adopted - truthfulness in commercial transactions being the most obvious one.9 Utilitarian ethical rules have the general characteristics that the individual perceives an

advantage to adhering to the rule if (nearly) everyone else also adheres to the rule.

There are at least two perspectives from which the .individual can consider a proposed rule: in vivo (i.e. from within the living or-ganism) or in vitro (i.e. from without the living organism). An in vivo utilitarian ethical rule is a rule that appears to be advantageous to the incH-vidual in the circumstances he finds himself in. Both the chairman of the board and the clerk in the mailroom are likely to be able to come up with sets of rules that they would find to be incli-vidually advantageous, however, those sets of rules would have little in common. And, when there is a disagreement over an ethical rule, there is little likelihood that it will be followed and hence the rule will not be sustaining. 10 While some in vivo rules are sustaining (e.g. do not poison the company's water cooler), many other rules can be sustained only if there are fre-quent role reversals - the chairman of the board and the mailroom clerk periodically change places. 11

This problem is of course not new to moral philosophy. Several devices have been proposed to introduce a semblance of objectivity to the selection of rules. Adam Smith posits an impar-tial spectator within each individual who arbit-rates ethical issues. Harsanyi ( 1976, p. 45) has individuals select rules before they know what their situation will be. Gaa (1986, p. 438-439) describes this idea in the context of drawing up rules for the functioning of securities markets:

9 Mitnick ( 1986) offers an interesting critique of the economics and accounting literature in agency theory from the per-spective of an organization theorist in which he points out that" [ m ]any norms are relevant to agency; most are ignored by writers in the AFE [accounting, finance, economics J tradition. Examples of such norms are reciprocity, helping, giving, the valid-agreements-should-be-kept norm, and what I call the fiduciary norm. The fiduciary norm, which instructs the agent to act solely for the principal, is one of the coping mechanisms ... ; it is a way for the principal to economize on specification and policing costs" (pp. 27-28). 10 If everyone agrees that a particular rule would be advantageous, it can be a sustaining rule. TI1is does not imply, however, that it will be sustaining. The question of how such rules can be enforced is left to the next section. Nevertheless, if there is a disagreement concerning the desirability of a rule, it will not be followed by everyone and those who favor the rule may eventually come to realize that the expected quid pro quo is not forthcoming. 11 See, for example, "the poverty game" as described by Hammond ( 1975 ). In this game, there are two players who alternate between having nothing and having everything in an infinite sequence of periods. If utility is concave in consumption and goods cannot be stored from one period to the next, then there is a cooperative equilibrium in which goods arc transferred from the player who has to the player who has not within each period.

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The key . . . is the postulation of a representative sec-urities market agent who is to decide on the basic struc-ture of that market. This is done by defining a hypotheti-cal situation of uncertainty in which securities market agents are uncertain about their own position (i.e., as manager or investor) in the market. In Rawls's [ 1971] ter-minology, decision makers are thus forced to make deci-sions from behind a "veil of ignorance". The veil of ignor-ance idea is a theoretical device which produces a purely hypothetical situation. Its primary funqion is to produce a condition qf so-called radical uncertainty ... by taking away from individuals any information which might en-able them to identify their own position in the resulting structure. They are thus prevented from making a choice that is in their own personal interest (without regard for the interests of others).

Operating behind such a veil of ignorance, one might well agree to constrain one's own actions in exchange for guarantees from others thatthey would constrain their actions as well. When viewed from behind the veil of ignorance, if these guarantees could be costlessly enforced, everyone would be better off. Many of the seri-ous systems pathologies that operate in a free market in the presence of unconstrained oppor-tunism would simply disapper. If for example, everyone were to agree to be truthful in their business dealings, many more contracts would become possible and the very large costs in-volved in monitoring and inefficient risk-sharing could be avoided. Such an agreement to mutu-ally constrain behavior could be labeled an in vitro utilitarian ethical code.

If enough people adhere to the ethical code, the economic pie enlarges enough to compen-sate for the ex post loss in freedom. Resources can be diverted away from monitoring, enforc-ing and protecting into more productive uses. The obvious difficulty is that an ethical code can be only rarely enforced in the way agreements are ordinarily enforced- by sanctions in case of an observed breach.

HOW IS THE ETHICAL CODE ENFORCED?

In the usual agency theory model, an ethical code (a form of contract) would be enforced by rewarding compliance and punishing breaches. In some markets (e.g. the wholesale diamond market in New York City) there are seldom for-mal contracts; there is instead a high degree of trust among the regular participants in the mar-ket. If a trader is discovered to have acted unethi _ cally, he is excluded from the market and loses his investment in human capital. This enforce-ment mechanism works only when the conse-quences of being caught are very large. The es-sence of the agency problem is that it is difficult or impossible to observe the offending behavior, so when the offending behavior is observed, the penalty must be very large or there is no effec-tive deterrent.

While explicit sanctions may be effective in some cases, there are a number of ways by which an ethical code might be enforced outside of the agency theory model.

Religion as an enforcement mechanism As Schelling ( 1968, p. 34) points out, an om-

niscient supernatural being who metes out re-wards and punishments neatly resolves the problem of enforcement of the ethical code. And, it can be argued that historically religion has served such a function. 1213 Durant ( 1959, p. 44) views the Catholic church as a civilizing force at the onset of the Dark Ages:

As the old order faded away in corruption, cowardice, and neglect, a unique army of churchmen rose to defend with energy and skill a regenerated stability and decency of life. The historic function of Christianity was to re-establish the moral basis of character and society by providing supernatural sanctions and support for the uncongenial commandments of social order.

12 It would be a gross over-simplification to suggest that the only function of religion is to subdue the untrammeled oppor-tunism of man or that this subjugation comes without cost. And certainly, not all altruistic or religious behavior is motivated by a heaven/hell calculus. Finally, apart from supplying a supernatural enforcement mechanism, religious organizations have helped to sustain behavioral norms which, as discussed later, probably are critical in enforcing ethical behavior.

13 More subtly, Weber [ 1957] argues that the spread of ascetic Protestantism- and in particular, the idea of a "calling" to a particular life's work- provided the psychological conditions for the development of capitalism. Divine will ordained a fixed calling (consistent with division oflabor) and pursuit of profits- but not ideal enjoyment of wealth. A materially com-

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Indeed, Durant (1959, p. 360) claims that this civilizing function is common to Christianity, Judaism and Muhammadanism:

The three religions agreed in rejecting the practicability of a natural- non-religious- morality; most men, they believed can be persuaded to tolerable behavior only by the fear of God. All three based their moral code on iden-tical conceptions: the all-seeing eye and all-recording hand of God, the divine authorship of the moral code, and the ultimate equalization of virtue with happiness by post-mortem punishments and rewards.

Genetics as a mechanism for reinforcing an ethical code

Hirshleifer ( 1977) and Becker ( 1976) argue that individuals are biologically programmed to adhere to at least some parts of an ethical code. Such biological programming can be used to explain altruistic behavior within the family. For example, a gene that fosters nurturing of help-less infants will tend to be passed on. However, it is not obvious that nature will favor a gene that inhibits, for example, self-seeking calculated lying outside of the immediate family.

Behavioral norms and the conscience as en-forcement mechanisms

In some situations, the mutual advantages of implicit cooperation will be apparent to all par-ties and an implicit (but unenforceable) agree-ment to cooperate may emerge. The Prisoner's Dilemma is a game in which implicit coopera-tion is mutually beneficial. The normal form of the game (Rapoport & Chammah, 1965) is:

Player I

e, D,

e" r,r s,t Player II

D" t,s p,p For example, if player I selects action C1 and

player II selects action Dn, then player I receives the payoff t and player II receives s. The dilemma arises when the payoffs satisfy the inequalities s

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cooperation in at least 199 of the 200 trials of the game with ten of the fourteen competing strate-gies. With respect to the results of the second tournament, Axelrod ( 1980b, p. 3 79) reports that

The winning rule was once again TIT FOR TAT ... The analysis of the results shows the value of not being the first to defect, of being somewhat forgiving, but also the importance of being provocable.

Pruitt & Kimmel (1977, pp. 376-377) report that in behavioral experiments involving pris-oner's dilemma games, the extent of mutual cooperation is a U-shaped function of the num-ber of trials played.

At first, most subjects concentrate their attention on the trial at hand. Some choose D in order to exploit the other or defend themselves from his anticipated efforts at exploitation. Others choose C out of confusion or be-cause of concern for the collective welfare and then shift to D as a reaction to the other's D playing. This leads to a period of mutual noncooperation and poor outcomes that encourage thought about the situation. At this point . . . (a) each party begins to see himself as dependent on the other, (b) exploiting the other ... begins to seem hopeless, and (c) the basic choice becomes one between mutual cooperation (CC) and mutual noncooperation (DD). The result is a longer range perspective focusing on the goal of achieving mutual cooperation.

The good news is that people (and cleverly designed automated strategies) do cooperate when it is mutually beneficial. The bad news is that in these games, a period of noncooperative behavior seems to be often necessary in order to convince the players of the mutual benefits of cooperation. Pruitt & Kimmel (1977, p. 370) emphasize, however,

[E]xperimental games usually place people in an un-familiar strategic environment . . . [W]ell-rehearsed habits of analysis and behavior are not readily available, and subjects must innovate ... They engage in cool calcu-lation and view their opponent in impersonal terms ... In such a setting, conventional social norms, attitudes, senti ments, and most social motives have relatively little im-

pact on behavior because they seem irrelevant to the task at hand.

It is likely that behavioral norms and ethical rules may lead to a mutually beneficial coopera-tive solution much more quickly than learning-by-abortive-exploitation. Furthermore, in the prisoner's dilemma games, one player always knows at the end of a round what action the other player selected; but, in the typical agency theory situation, the principal is never really sure whether the agent has been cooperating or not in any one round, so the learning occurs much more slowly. Therefore, particularly in agency theory situations, behavioral norms may be much more efficient in inducing optimal solu-tions than learning-by-doing.

Providing that behavioral norms are suffi-ciently unambiguous, it appears that they can be effective in facilitating exchanges between people. 14 For example, people tip when they are out of town at a restaurant they will never visit again. This behavioral norm resolves a specific . agency problem. Service is improved if there is some mechanism for rewarding adequate ser-vice by waiters. Customers are in a better posi-tion to know the quality of service provided than even the waiter's immediate supervisor. It doesn't make sense to tip before the meal, since the customer at that point doesn't know what the service will be like. Tipping after the meal in-troduces a problem. Repeat customers have some incentive to tip, but one-time customers have no inherent incentive to tip. As a conse-quence, waiters would be reluctant to serve any-one other than regular customers and would provide only perfunctory service to anyone else. The solution is for everyone to agree to tip, if ser-vice is adequate, even when not returning to a restaurant. 15 This is a behavioral norm that makes market exchanges more efficient and it is enforced by a sense of guilt if violated. 16

14 McKean [ 1975, pp. 35-36] suggests that one of the conditions for an effective ethical code is that it be relatively unambigu-ous. "With an ambiguous rule, one docs not know exactly what he is supposed to do or exactly what he can depend on others doing. In short no one knows with any precision what the social contract is or what gains can be expected from it, and it is comparatively vulnerable to erosion." 15 I am indebted to Graeme Rankine for suggesting this example. 16 Lynn & Oldenquist ( 1986) cite evidence of the existence of "group-egoistic" and "moral" motives in experiments in psychology which serve to attenuate opportunism.

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Arrow ( 1974, pp. 26--27) underlines the cen-tral role of the conscience in efficient function-ing of social systems:

Certainly one way of looking at ethics and morality ... is that these principles are agreements, conscious or, in many cases, unconscious, to supply mutual benefits ... Societies in their evolution have developed implicit ag-reements to certain kinds of regard for others, agree-ments which are essential to the survival of the society or at least contribute greatly to the efficiency of its working ... [T]he fact that we cannot mediate all our respon-sibilities to others through prices ... makes it essential in the running of society that we have what might be called "conscience", a feeling of responsibility for the effects of one's actions on others.

As Nagel ( 1975, pp. 63--64) points out, these mutual benefits are not necessarily of the narrow quid pro quo variety one finds in the prisoner's dilemma game.

When one person donates money to his old college, or gives blood, or gets at the end of the line to buy subway tokens, or cleans up a campsite after he has used it, he may explain such behavior by saying that he has benefit-ted from similar behavior by others. This has the look of a straight exchange, but it is not; he benefits from like ac-tions from others, but neither those actions nor the bene-fit are contingent on what he himself is doing now. And if you point out that his likelihood of receiving blood in the future if he should need it is not significantly increased by giving today, that will rightly be dismissed as irrelevant. He is not under the illusion that he is engaged in a trade.

What is the correct account of the motive for such be-havior? It is not simple self-interest, or simple altruism either, for the explanation does refer to benefits re-ceived. The person is making a contribution to a practice or institution in the knowledge that it benefits him and is dependent for survival on contributions from people like him. He is not willing to be a free rider because it would be unfair.

Rawls ( 1971, p. 112) echoes this theme: [W]hen a number of persons engage in a mutually advan-tageous cooperative venture according to the rules, and thus restrict their liberty in ways necessary to yield ad-vantages for all, those who have submitted to these re-

strictions have a right to similar acquiescence on the part of those who have benefitted from their submission.

Behavioral norms (or ethical rules) are clearly a most fragile enforcement mechanism. The suc-cess of behavioral norms in enforcing utilitarian ethical behavior crucially depends upon what people think the norms are. If everyone thinks it is normal behavior to cheat and deceive, then people will cheat and deceive without feeling guilty. Not surprisingly, in prisoner's dilemma experiments it has been found that people who believe others will cooperate are more likely to cooperate themselves (Dawes, 1980, pp. 187-188).

How are behavioral norms established? The behavioral norms that are of concern in this paper are those t!Jat serve to reduce agency costs by moderating certain self-seeking be-havior. It is inherently difficult to observe whether an individual is conforming to such be-havioral norms or not. Hence, example has ali-mited role in passing on such norms. Primarily, these norms must be passed on by instruction. 17 Not surprisingly, in experimental games people who understand the benefits of cooperation are more likely to cooperate (Dawes, 1980, p. 190). And, apparently some sermonizing even may help (Dawes, 1980, p. 188).

Behavioral norms are probably empirically reinforced largely through the absence of counter-examples. 18 That is, if people are in-structed that they should not steal, and they do not observe anyone stealing, they will tend not to steal.

In business organizations, management may have a key role to play in developing an organiza-tional culture that fosters utilitarian ethical val-ues.19 A potentially testable proposition is that resources are devoted to such acculturation in

17 But, the costs of instruction may outweigh the benefits of reduced agency costs. 18 This suggests that shared values will be most successful as an enforcement mechanism in small, stable and homogeneous communities. In such communities, there will be fewer counter-examples to observe; and, when an individual is caught vio-lating a shared value, the offending individual is in actuality or effect cast out of the community. Since the individual is no longer a part of the community, the individual's behavior cannot serve as a counter-example for others. 10 Bolnick ( 1975) reports evidence from experimental sociology that group norms are powerful motivating devices- some-times more powerful than economic incentives- and that leaders are influential in setting those norms.

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direct proportion to the scale of potential agency problems inherent in the organization. For example, there should be more emphasis on fostering utilitarian ethical values in service or-ganizations where inputs and outputs are dif-ficult to measure than in manufacturing organi-zations where it is much easier to monitor per-formance. And, indeed, a distinguishing charac-teristic of professions (where the quality of the output is difficult for the consumer to assess) is an explicit ethical code.

SUMMARY AND CONCLUSIONS

In the presence of unconstrairied oppor-tunism, economic and social systems experi-ence profound difficulties. The agency theory literature, which assumes unconstrained oppor-tunism, demonstrates that, at a minimum, there is a dead-weight loss from monitoring activities and from incentive contracts that do not effi-ciently share risk. In extreme cases, markets col-lapse altogether from the weight of mutual dis-trust.

Certain kinds of ethical (i.e. self-constrained) behavior lubricate social and economic systems. If parties to a transaction believe that the other parties to the transaction are honest and act in good faith, the transaction may be possible where it would not have been possible and dead-weight losses can be avoided. The crux of the problem is that, by definition, the probability of being caught in an unethical act is small. Thus, sanctions cannot be generally effective in induc-ing ethical behavior.

Historically, religion has played a role in forcing ethical behavior by invoking an

~"'""'''' cient being with the power to reward and behavior. Genetics may also play some role . .

. fi . . h' I b h tn rem orcmg certam et tea e aviors. In addition to sanctions, religion and genetics, shared values (or behavioral norms) probably play a critical role in motivating ethical behavior.

Business school instructors may have some in-fluence over the values that their students take with them in~o the workplace. Using agency theory, the senous adverse consequences on the economic system of unconstrained oppor-tunism can be illustrated with some force. Unfor-tunately, there is also much potential for nega-tive influence on students. This is particularly true for those of us who are active in agency theory research. To a large extent, we condtict our research by grubbing around in the under-brush of business looking for evidence of oppor-tunistic behavior ancl of contractual counter: measures against such behavior. We need to keep in mind that while our models presume that businessmen are opportunistic and that we can fine! (statistically significant) examples of such opportunism and of counter-measures taken against such opportunism, it does not fol-low that businessmen generally are or should be opportui1istic. It would be a mistake to wittingly or unwittingly inculcate in the next generation of accountants and managers the notion that it is foolish, naive or abnormal for businessmen to feel constrained in their actions by ethical con-siderations. At least some varieties of ethical be-havior are not to be scorned; they are a neces-sary lubricant for the functioning of markets.

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THE ECONOMICS OF ETHICS

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