Re-evaluating Milton Friedmans Concept of Social Responsibility of Business - Essay Example

? Re-evaluating Milton Friedman’s Concept of Social Responsibility of Business Introduction “The primary and only responsibility of business is to use its 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 and fraud” - Milton Friedman (1970) The above mentioned lines are not only a quotation by the most influential economist in the second half of twentieth century but also the crux of this essay. Seminal research works of Milton Friedman (1970) has forced the researcher in this essay to look deep on role of ethics and ethical decision making in financial institution or more specifically for banking industry. In the first part of this essay, the researcher will try to define the concept of free competition and business ethics in the light of research works of previous research scholars. In the second part the study will understand role of business ethics and ethical decision making in context to banking industry. Although the concept of business ethics, fair and free competition, abolishment of monopolistic competition are pretty much older in comparison neo classical concepts like trade protection, corporate governance codes but surprisingly very few researcher have tried find how these implications are relevant in context to banking industry. To understand the importance of open and free competition it is essential for the researcher to analyze these concepts by using theories of economics (Misra and Arrawatia, 2012). Nature of Competition in Banking Industry In recent times, various research scholars have tried to investigate nature of competition in global banking industry with help of different concepts of economics. Modern economists have stated that conjoint impact of internationalization, liberalization and harmonization has changed the dynamics of competition in global banking competitions. Global banks are competing with each other in hypercompetitive market which is characterized by resource shrinkage, lack of diversity and saturation (Oliviera et al, 2010). In such context, it is easier for banks to understand first strata of the quotation of Milton Friedman that has mentioned above that their primary and only responsibility is to increase profit by using its resources whereas understanding the second strata such as doing business in open and free competition environment without engaging in deception and frauds (Cheng, 2011). There is no doubt the world has changed a lot from the time Milton Friedman defined the responsibility of managers. In twenty first century, the world has seen many of the major financial scams, financial frauds, unethical competitions hence it is necessary to analyze the viewpoint of Milton in context modern business world. Now the fact is that, research scholars have raised question over the assumption of Milton Friedman in context to banking industry. For example, competition in banking sector has been created due to multitude of factors such as financial markets deregulation, liberalization, consolidation, merger between various financial institutions etc hence it will not be justifiable to take a unilateral approach to analyze the level of competition in banking sector. The study will take help of research works of eminent research scholars such as Bresnahan (1982) to understand competition theories in context to banking sector. According to Bresnahan (1982), market power of a bank is should be analyzed with the help of mark-up of price instead of marginal cost of a particular bank. The proposed model was based on two equations such as supply equation and inverse demand equation in context to first order profit maximization (Misra and Arrawatia, 2012). Shaffer (1993) has found that North American banks were competitive during 1965 to 1990 when the market was consolidated in nature. In that period, few North American banks competed in partially monopolistic competition environment where they had created entry barrier for small players. Opposite results were found by research scholars such as Berg and Kim (1996) and Fuentes and Sastre (1998) when they conducted research on banking industry of Spain and Norway. According to these research scholars, Norwegian and Spanish banking industry was less competitive in nature in context to their North American counterparts during early 1990’s. According to Berg and Kim (1996), concept of open and free competition was prevalent in Spanish and Norwegian banking sector in comparison to North American banks during the same period of time. It has been observed by the economists that, competition in banking industry increases when banks set marginal prices lower than the marginal costs. Panzar and Rosse (1987) have given the concept of PRH-statistic or bank’s revenue with respect to bank’s input price in order to identify whether the bank is engaged in open and free competition or it trying to perturb the completion equilibrium in the market. Sum of the elasticity in PRH value can be used for understanding the market competition (Prasad and Ghosh, 2007). Nature of Competition PRH-Statistic Comment Perfect 1 One unit rise in input price will lead to same amount of rise in the revenue of the bank. Monopoly -1 to 0 Increase in marginal cost of the bank would reduce or non-effect the revenue of the bank. There are researchers who have proposed alternate methodology to determine the nature of competition in banking industry. For example, Oliviera et al (2010) have stated that to identify whether a bank is operating in free and fair competition environment one has to identify the impact of lending channel of banks on economic policy of a particular country. Suppose Bank X and Bank Y is operating in United Kingdom (UK), financial and market position of bank A is much stronger in comparison to bank B, now UK government has tightened the monetary policy for banks in order to reduce the burden of external debt and get rid of economic recession. Let’s assume that neither bank A or bank B is involved in any kind of financial fraud and deception, whatever the ethical orientation of business process of each of the bank, under natural circumstances, tighter monetary policy of government will hurt more the bank B in comparison to bank A. In such cases, concept of free and fair competition is needed to be reviewed in order to make it effective in those situations where macro environmental factors decide the competition dynamics. Gunji et al (2009) have also pointed out that, monetary policy of government has significant impact in determining the nature of competition in banking sector. Vives (2010) has strongly argued that, during recent economic recession and sovereign debt crisis, the concept of competition in banking sector has seen paradigm shift because not only financial frauds and deceptions were the cause behind the failure of some major banks during that period but wrong financial policy and unethical behaviour of top level managers have also influenced the completion dynamics of the banking industry during that period. Research scholars have analyzed the market competition in different European banking industries such as UK, France, Germany etc; they have found that banking industry in the European region is fairly fragmented and extent of free and fair completion is significant (Bikker and Haaf, 2002 and Stavarek and Repkova, 2011). In recent time, financial fraud by various financial institutions and non-financial institutions has forced the management researchers to dig deep on the topic. Now the question is, whether accounting fraud, deception and financial scam can influence market completion or not. The answer to the question is not simplistic in nature because interrelation between financial fraud and market competition is asymmetric in nature. The asymmetry between variable has been further intensified by the involvement of the concept of business cycle. According to the research work of Wang and Winton (2012), tendency of financial and deception increases during the time boom in business cycle in comparison to bust period. Economists have pointed out that, product market competition is most vulnerable in context to any kind of financial fraud or deception by financial institutions. The concept of fraud and deception is little tricky in context to financial market, for example, a bank can use internal information of rival banks in order to adjust its performance which can help them to achieve competitive advantage over rival firm. Accessing insider information of other financial institution in illegal manner in order to improve business performance can be viewed as fraudulent activity. Financial market is volatile in nature; using information of other financial institution in deceptive manner can help a bank to influence the market competition in effective manner. Taking help of the research findings of Wang and Winton (2012), it can be said that a bank can influence the market completion by committing financial fraud and deception in three way manner, such as 1- accessing product market information of rival bank in illegal manner, 2- misrepresenting the market and financial performance of the bank to shareholders in order to beat the market expectation and 3- involving in money laundering activities in order transfer illegal moneys or hiding the source of the money. However the third channel of committing financial fraud is relatively new in nature but other two channels have long history of altering equilibrium of market competition. For example, banking crisis in UK was caused by corporate governance failure in banks, during the crisis period, majority of banks have failed to incorporate corporate governance policies which can reduce the market risks. Northern Rock bank has misrepresented its financial performance to investors in order to gain short term market advantage Association of Chartered Certified Accountants, 2009). Peress (2010) has stated that, many of the banks rely on stock market indicators as absolute performance measurement index and hence show the tendency to access internal financial information of rival firms and use the information to alter market competition. However, relying on stock market performance as sole performance indicator not increase the tendency to commit financial fraud by banks but also creates disruption in the market competition (Hoberg and Phillips, 2010). Profit Maximization in Banking Sector According to Milton Friedman (1970), one and only responsibility for any business is to maximize its profit. Unfortunate fact is that, although there is no doubt about the genius of Milton Friedman but the scholar has not provided detailed justification for his claim. Perception of Milton Friedman can be used by banks as economic defence for their profit maximizing behaviour. A small excerpt of seminal work of Milton Friedman (1970) can be used to understand the concept of profit maximizing in ethical manner, organizations should use its resources to maximize profit while “conforming to the basic rules of the society, both those embodied in law and those embodied in ethical customs” (Friedman, 1970, p. 37). Let’s try to justify profit maximization concept of Milton Friedman; owners of the business are shareholders who are part of the society, these shareholders invest money to run the business hence it is sole responsibility of managers to take care of interest of shareholders and maximize profits so that shareholders can earn higher return on their investment. Analyzing the research work of Orlitzky et al (2003), it can be said that financial institutions such as banks are responsible for their action to shareholders and they should involve in those ethical actions which are profitable. Milton Friedman never stated that business should go for profit maximization by involving in fraudulent and deceptive activities which can help them to get unfair advantage in market competition. Hence it will be wrong to think that profit maximization behaviour of any bank creates barrier for performing corporate social responsibility which is one most sought after dimension of business ethics. Concept of corporate social responsibility was still at the nascent stage when Milton Friedman gave the concept profit maximization hence it can be assumed that, it was for renowned economist to consider corporate social responsibility as integrated part of profit maximization. However, recent research work of Kolstad (2007), Wood (2010) and Garcia-Castro et al (2010) have revealed that there is positive correlation between profit maximization, corporate social responsibility (CSR) and environmental responsibility of business. Research works of these research scholars have further strengthened Milton Friedman’s view point on responsibility of business. Banks are trying to comply with the objectives of CSR to ensure sustainable development from early 2000s with the help of socially responsible investment (SRI) and equator principles. However CSR initiatives in banking industry are limited in comparison to other industries because banks still believe that CSR is a wasteful activity. Civil society perceives banks as wealth creation entity hence it is tough for banks to nullify the fallacy and involve in aggressive CSR activities. Relano (2011) has raised interesting facets while discussing ethical responsibilities in banking industry, according to the scholar; it is not expected from a bank to create direct impact on environment but it is expected from them to take indirect role such as financing environment sustainability projects which can ensure sustainable development. According to Wood (2010), investing money on corporate social responsibilities can help financial institutions to improve their social image in the society and alternatively attracts investors to invest money on the bank. However, very little research work has been done for understanding the role of corporate social responsibility to improve the market performance of a bank hence it was not possible for the study to justify theoretical model of Milton Friedman for banking industry in context to CSR activities. In such context, disclosing firm specific information such as financial position, cost of borrowing, liquidity to shareholders and stakeholders can decrease the chance of committing fraud or deception by banks (Clinch and Verrecchia 1997). Business Ethics and Ethical Decision Making in Banking Industry It has been already mentioned that banks should restrain themselves from committing financial frauds or deceptions which can alter the balance of competition in the market place. In such context, concept of business ethics should be understood by the banks in order to deploy its resources to maximize profits by playing the game in accordance with the rules of the game. Velasquez (1996) has given a simplistic definition of ethics, according to the scholar ethics is the moral principal of particular individual which can help them distinguish what is right from what is wrong. In context to business environment, concept of ethics includes multitude of aspects such as social responsibilities, non-participating in unfair competition, taking care of the interest of internal and external stakeholders, maximizing profit for shareholders, consumer autonomy, compliance with the corporate governance codes and restraining from committing financial frauds. Careful investigation of ethical norms of business reveals that most of them support Milton Friedman’s ideology on responsibility of business. For example, according to Kotler (1997), companies can achieve competitive advantage with the conjoint effort of cost advantage and value advantage; it is very difficult for an organization to achieve these advantages in longstanding manner without maximizing the profit. Banking belongs to service industry which is plagued by, inseparability and in tangibility. Hence, it is very importance for banks to focus on both reputation and performance in order to remain relevant in societal context (Brickley et al., 2003). Involving in fraudulent activities such committing accounting frauds in order to present wrong or inflated financial performance result to investors in order to lure them to invest, accessing information of other banks in illegal manner and then use the information to win market competition, concealing or transferring money through cross border transactions without complying with government norms do not help a bank to improve its market position in sustainable manner. However there are other ways in which a bank can achieve unfair advantage in market competition. For example, banking industry works as an intermediate channel between depositors and creditors hence it is expected by both creditors and investors that banks show integrity, social responsibility and compliance while transacting money (Solaiman et al., 2007). Issues like, accepting bribe from customers in order to pass loans, lobbying for unethical reasons, lending to connected parties, misrepresenting interest of customers are the other side of fraud and deception that a bank can do. Unfortunately, there are corporate governance codes which can guide a bank to maximize profits without hurting the interest of shareholders but still there are no such codes available which can help a bank to maximize profit without neglecting interest of customers. Frenkel and Lurie (2003) has stated that information availability to customers separate a ordinary bank from a ethical bank, for example, a ordinary do not disclose detailed information of banking transactions to customers where as ethical bankers focus on improving knowledge of customers. Now the question is that, can a bank achieve competitive edge in market competition without involving fraudulent activities which neglect the interest of customers. Hill and Jones (2004) has used tricky method for answering the question, according to tem a bank can maximize its profits by doing business without neglecting the interest of customers. Suppose bank A conducts its business in ethical manner and do not participate in fraudulent activities which can hurt the interest of customers, customers will automatically prefer to do transactions through bank A due to its clear brand image, repetitive customer transaction will ensure higher customer value which will not only increase degree of cost leveraging but also reduce cost of serving the customer, ultimately profit of the bank A will increase. Justification given in context to customer driven profit maximization is also supported by the research work of Holme (2008) and Solaiman et al (2007). Conclusion It is evident from the above discussion that the concept of Milton Friedman about the responsibility of business is still relevant in context to banking industry. The study has not only tried to justify the viewpoint of the eminent economist but also stretched the idea in context to customer driven profit maximization for banks. In the light of the above discussion, it can be said that there justification behind the claim that sole responsibility of business is to increase its profit. After analyzing research work of various research scholars, it can be said that a bank can increase its profit without committing fraud or deception which can not only disturb the environment of open and free competition but also hurt the interest of customers and shareholders (Hazarika et al, 2011). Reference Association of Chartered Certified Accountants., 2009. A Review of Corporate Governance in UK Banks and Other Financial Industry Entities. Comments from ACCA. [Online] Available at: [Accessed 19 April 2013]. Berg, S. and Kim, M., 1998. Banks as Multioutput Oligopolies: An Empirical Evaluation of the Retail and Corporate Banking Markets. 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