The Social Contract:
Moral Obligation or Regulation
Learning objectives
• Define and explain Utilitarianism and Classic Liberalism.
• Explain the basics of the agency problem.
• Critique the free market system and underlying theories.
• Describe the End of History thesis.
• Distinguish between wealth and welfare.
• Explain the Organizational Failure Framework.
Classic Liberalism and Utilitarianism
• Classic Liberalism
• Utilitarianism
The concept of Utilitarianism was developed as an
extension of Liberalism in order to account for the
need to regulate society in terms of each individual
pursuing, independently, his or her own ends.
Classical Liberalism
Classical Liberal theory started to be developed in the
seventeenth century by such writers as John Locke as a means of
explaining how society operated, and should operate, in an era in
which the Divine Right of Kings to rule and to run society for their
own benefit had been challenged and was generally considered to be
inappropriate for the society which then existed.
Classical Liberal therefore is centered upon the individual, who is
assumed to be rational and would make a rational decision, and is
based upon the need to give freedom to every individual to pursue
his or her own ends. It is therefore a philosophy of the pursuance of
self-interest.
Utilitarianism
It was developed by people such as Bentham (1789) and John
Stuart Mill (1863) who defined the optimal position for society as
being the greatest good of the greatest number. They argued that it
was government’s role to mediate between individuals to ensure this
societal end.
In 1762, Jean-Jacques Rousseau produced his book on the Social
Contract which was designed to explain – and therefore legitimate –
the relationship between an individual and the society and its
government. In it he argued that individuals voluntarily gave up
certain rights in order for the government of the state to be able to
manage for the greater good of all citizens. Thus the idea of the Social
Contract has been generally accepted.
The basics of the agency problem
The general agency problem can be characterized as a situation in
which a principal (a group of principals) seeks to establish incentives
for an agent (or group of agents) which takes decisions that affect the
principal to act in ways that contribute maximally to the principal’s
own objectives. In business this means the relationship between the
owner of the business and other investors—as principal—and the
managers of the business—as agents. The difficulties in establishing
such an incentive structure arise from either divergence of the
objectives of principals and agents or the asymmetric information
between principals and agents, and very often from both of these
factors.
The free market system and
underlying theories
The free market system is a pluralistic paradigm. Such a paradigm
views organizations not as entities acting for a particular purpose but
rather as a coalition of various interest groups acting in concert,
through the resolution or subsumption of their convergent interests,
for a particular purpose at a particular point in time. This purpose
changes over time as the power of the various stakeholders changes
and as various stakeholders join, and influence, the dominant
coalition whilst other stakeholders leave that coalition.
The Principle of Sustainability
It is a term which has suddenly become so common as to be
ubiquitous for business and for society. It is of major concern to
business, and to academics concerned with business, and is therefore
of great relevance to a study of corporate social responsibility.
Governance and the ethics of corporate behavior also are items of
considerable interest and importance, especially given the unfolding
of events surrounding the 2008-10 economic crisis and the claims
made about individual, corporate and state behavior – or more
accurately misbehavior. It is found that social responsibility demands
individual responsibility.
A theoretical basis to underpin CSR
Stakeholder theory
Social contract theory
Political economy theory
Wealth and welfare
Individual profit
Social interest
Classical liberalism
Utilitarian philosophy
Shareholders & stakeholders
Interests & ethics
The Organizational Failure Framework
The main people involved in the control of a firms are, of
course, its managers and Williamson (1970) argues that because in
any large organization the management of the firm is normally
divorced from its ownership then this is a factor which hinders its
control and decision making. This leads to internal efficiencies
within the firm and conflicts of interests, which mean that
organizations do not operate efficiently as a means of transaction
cost-minimization and value-creating maximization. From this
analysis Williamson developed what is known as the Organizational
Failure Framework.
He argues that organic growth beyond a certain size
leads to failure, thereby limiting the size of a firm. Whilst this
theory has a certain logic to it, practical examples of such
activity are lacking and there do appear to be some very
large firms in existence in the world. Perhaps, however,
current trends towards downsizing and returning to core
business aims is evidence of the validity of this theory, but
some empirical testing seems to be needed. These factors
together are described as the Organizational Failure
Framework, which describes how firms collapse through
becoming too big; arguably this is what has happened to
some of the major financial institutions currently having
problems.
Conclusion
The severance of responsibility from risk—through allowing
abnormal returns to not just be made but also allowing the
expectation that these have become the norm – is clearly an
unrealistic belief.
The concepts of risk and responsibility are actually inseparable,
and elementary finance theory teaches us that arbitrage will quickly
eliminate abnormal returns.
There is a need to introduce morality into the marketplace and
into the economic system. Only then can we ensure that crises such
as we have witnessed will not recur.
Summary of key points
• Financial misdemeanors have created a concern for CSR. This includes
reckless behavior and fraud and theft.
• Utilitarianism, based upon Classical Liberalism, is the underlying
philosophy of the market system.
• The Free Market is a cause of problems.
• Globalization has limited the ability of regulators to control the financial
markets.
• The agency problem means that all information is not known to
potential investors.
• The Organizational Failure Framework explains inefficiencies in firm
behavior.
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