The Ethical Economy and Competitive

Journal of Economic Psychology 26 (2005) 732–757
www.elsevier.com/locate/joep
Critical Commentary
The ethical economy and competitive

markets: Reconciling altruistic, moralistic,
and ethical behavior with the rational
economic agent and competitive markets
Morris Altman *
Department of Economics, University of Saskatchewan, 9 Campus Drive, Saskatoon, SK, Canada S7N 5A5
Available online 15 July 2005
Abstract
Contrary to some of the leading critiques of neoclassical theory, I argue that this theoretical
framework can incorporate the moral dimension into the modeling of economic agents when
the consequences of their choices are not answerable to market forces. Neoclassical theory,
broadly defined, simply stresses the potential trade-off that exists between altruistic or ethical
behavior and the material well-being of the individual. Nevertheless, the behavioral assump-
tions of neoclassical theory are too narrow to deal with the potential ramifications of introduc-
ing the moral dimension into the objective function of workers, managers and owners. The
conventional wisdom predicts that moral or ethical firms cannot survive in a competitive mar-
ket since it is assumed that such firms must produce at relatively higher unit costs. However,
higher cost firms can survive as demand is restructured towards the output of the relatively
ethical firms. Moreover, modifying mainstream economic theory by introducing more realistic
behavioral assumptions into the modeling of the economic agent allows for the simultaneous
survival over time of both unethical and ethical firms that are cost competitive and profitable.
These revisions of the conventional wisdom have important implications for public policy as
well as for an understanding of the actual scope that is afforded to firm decision makers with
regards to altruistic or ethical behavior.
Ó 2005 Elsevier B.V. All rights reserved.
*
Tel.: +1 306 966 5198; fax: +1 306 966 5232.
E-mail address: altman@sask.usask.ca
0167-4870/$ - see front matter Ó 2005 Elsevier B.V. All rights reserved.
doi:10.1016/j.joep.2005.06.004
M. Altman / Journal of Economic Psychology 26 (2005) 732–757 733
JEL classification: B4; D2; J5; L1; L2
PsycINFO classification: 2630; 2900; 3000; 3900; 3660
Keywords: Altruism; Ethical; Behavioral; Rational; Demand
1. Introduction
One seemingly poignant critique of contemporary economic theory is that it has

failed to incorporate into its corpus the notion of altruism, morality, and ethics, this
being particularly true of mainstream neoclassical theory. It is asserted, that eco-
nomic theory assumes that economic agents are completely self-interested in terms
of their underlying motivational structure, especially with regards to maximizing
their material well-being, and that this assumption biases the analytical predictions
of economic theory in an unreasonable and unrealistic fashion that runs contrary to
the stylized facts of economic behavior. Therefore, it is argued that contemporary
economic theory is fatally flawed (Etzioni, 1988) or in need of an overhaul (Altman,
2004; Frank, 1988; Gintis, 2000, 2003; Gowdy, 2004; Hausman & McPherson, 1993;
Henrich, 2004; Kahneman, Knetch, & Thaler, 1986a, Kahneman, Knetch, & Thaler,
1986b; Khalil, 2004; Sen, 1988; Simon, 1993; Yeager, 2001; Wilson, 1999, Chapter 9)
to allow for the moral dimension of the economic agents thereby clearly incorporat-
ing altruism, morality, and ethics as a critical component of the underlying motivat-
ing structure of economic behavior.
I argue that these critiques largely focus upon one particular theoretical perspec-
tive that builts on a very narrow definition of rational economic behavior. In fact,
altruism and other types of virtuous behavior can be incorporated into the behav-
ioral function of the economic agent, even within the neoclassical analytical frame-
work (Becker, 1996), especially when the behaviors of the economic agent is not
subject to market forces. Nevertheless, the conventional wisdom has steered away
from this important task, since most tend to assume that individuals are largely con-
cerned with maximizing utility in terms of their material well-being and it is further
assumed that virtuous behavior typically incurs pecuniary and/or non-pecuniary
costs. It is moreover maintained that a rational agent would not make such a
trade-off between virtuous behavior and assumed opportunity costs and moreover
that such a trade-off is not sustainable. This gap in the literature between the narrow
conventional wisdomÕs perspective on virtuous behavior inclusive of altruism and a
more realistic perspective consistent with conventional economic theory must be ad-
dressed.1 Indeed some of the above mentioned critics do indeed make important con-
tributions to this end.
1
There are many definition of altruism (see Khalil, 2004, for example). I am most concerned with
addressing the definition that holds sway amongst contemporary economic theorists. For a discussion of
different contemporary efforts to introduce altruism into the modeling of the economic agent (see Khalil
(2001, 2004)). Khalil offers an alternative approach to altruism based on Adam SmithÕs concept of
sympathy. See also Muller (1993).
734 M. Altman / Journal of Economic Psychology 26 (2005) 732–757
I argue that economic theory, broadly defined, simply stresses the potential trade-
off that exists between altruistic behavior and the material well-being of the individual
and that this trade-off affects the decisions made by self-interested decision makers.
The explicit recognition and understanding of this potential trade-off remains a vital
component of the modeling of the economic agent even with the incorporation of the
moral dimension into the behavioral function. Ethical and moral behaviors, and more
generally virtuous behavior, can be looked upon in the same fashion when they in-
volve material opportunity costs. Ethical or moral behavior need not be materially
costly but it is often so regarded in the literature. Such costs are likely to accrue when
moral or ethical behaviors are other-regarding or benevolent thereby overlapping
with the colloquial definition of altruism. When individual behavior is not con-
strained by market forces, I argue that the extent of altruistic and, more generally, vir-
tuous behavior is a matter of individual choice as structured by the preference
function of the individual which incorporates the notion of the prospective material
opportunity costs of engaging in virtuous behavior. The preference function of the
individual need incorporate both the cultural and biological determinants of such
behavior, typically ignored in the conventional economics literature.2 One also has
to incorporate into the modeling of the economic agent the possibility that virtuous
acts need not be costly. This is especially the case when one incorporates the notion
reciprocity into ones analysis, when oneÕs costly but virtuous acts are compensated in
either the short or long run or there is the expectation of such compensation.3
When altruistic or ethical behavior characterizes the decision making of economic
agents, such as firm managers and owners, who are subject to market forces, eco-
nomic theory demands that such behavior be reconciled with the survivor principle.
Altruistic or ethical behavior must be consistent with firm survival on the market
place otherwise altruistic and ethical managers and owners will lead their firms
invariably into bankruptcy. The conventional wisdom assumes that market forces
do not allow for altruistic or ethical behavioral. Given the behavioral assumptions
of conventional neoclassical theory altruistic or ethical behavior results in higher unit
costs and lower profits: ergo a less competitive firm. A key analytical prediction ema-
nating from the conventional wisdom is that altruistic or ethical firms will not sur-
vive in a competitive market unless there exists demand for ethical products
(Friedman, 1953, 1970). In fact, Friedman argues that a socially responsible firm,
broadly defined, is one that maximizes profits. Profit maximization itself, however
the output is produced and whatever is produced, is consistent with socially respon-
sible firm behavior. Any other form of firm behavioral is socially irresponsible since
it results in the demise of the firm or, at best, in lower returns to the firm owners
(Friedman, 1970).
2
See Hirshleifer (1978) for a detailed discussion of altruism in the context of contemporary economic
theory as contextualized by the biological sciences. See also BeckerÕs (1996) effort to endogenize preference
formation by relating this to social and cultural variables.
3
On the role of reciprocity in determining virtuous acts inclusive of altruism (see for example, Axelrod,
1984; Field, 2001; Hirshleifer, 1978, 1997; Trivers, 1971; Ridley, 1996). With regards to altruism, behavior
might appear to be self-sacrificing when it is not, if one incorporates reciprocity into ones analysis.
I argue that this worldview paints a too simplistic view of the profit maximizing
firm. The behavioral assumptions of neoclassical theory are too narrow to deal with
the potential ramifications of introducing altruism and ethics into the objective func-
tion of workers, managers and owners. Introducing more realistic behavioral
assumptions into the modeling of firm behavior allows for the survival over time
of ethical and altruistic firms that are both cost competitive and relatively highly pro-
ductive. A model is presented whereby profit maximization is consistent with a range
of methods of production and product types ranging from ethical or socially respon-
sible behavior to unethically socially irresponsible behavior. Thus the ethical firm
need not be a relatively high cost or low profit entity. Moreover, ethical firms can
be expected to be relatively more productive than unethical firms. I also maintain
that the conventional wisdom pays too little attention to the structure of demand
and changes to it over time and how this impacts on the capacity for ethical produc-
tion to take place even when such production is relatively high cost. This brings us to
a discussion of the microfoundations of demand. These modifications of mainstream
theory have important implications for public policy as well as for an understanding
of the actual scope that is afforded to firm decision makers with regards to altruistic
or ethical behavior.
2. The altruistic individual
Standard economic analysis, built upon neoclassical theory, has paid little heed to
economic behavior that is inconsistent with maximizing the material well-being of
the individual from a self-interested perspective. Materially selfish maximizing
behavior is considered to be both a good descriptor of typical human behavior
and a reasonable normative theory of the rational individual. Moreover, the conven-
tional wisdom often reads as if self-interested material maximizing behavior is the
only form of rational behavior afforded to the economic agent. Individuals are there-
fore expected to behave in this fashion if they are rational. A softer and albeit not
dominant version of this worldview suggests that, at a minimum, the typical individ-
ual does not pass over non-trivial opportunities for gain. This principle is articulated
by McCloskey as the Axiom of Modest Greed (1990, p. 112), ‘‘The average person
sees a quarter and sidles over it . . . he sees a $500 bill and jumps for it’’. An extension
of this axiom is that the average person might engage in modest self-sacrifice in terms
of leisure time or income for ethical and moral reasons. There can be exceptions to
this rule, but this would represent anomalous behavior according to the conventional
wisdom. The Axiom of Modest Greed therefore unequivocally predicts that any
moral act expected to yield a higher non-trivial income (such as a $500 dollar bill),
as opposed to a loss of income, will be undertaken. However, the Axiom of Modest
Greed focuses on the (opportunity) cost of doing good deeds and implicitly strips the
conventional worldview of its normative domain – one is not considered to be irra-
tional if one chooses to engage in material self-sacrifice. Such behavior is simply
not expected of the typical individual when the cost of being virtuous is relatively
high.
For critics such as Amitai Etzioni (1988), who come to their worldview from out-
side of the economics discipline, ethical or moral behavior that comes at a cost to the
moral individual should be the rule rather than the exception. Such Good Samaritan
behavior, he argues, is difficult to reconcile with the economic theory per se. Never-
theless, the moral dimension of human behavior can be incorporated into standard
theoretical framework even though economists have neglected what is considered to
be at best an anomalous form of behavior. In fact, this task has been accomplished in
part by one of the leading neoclassical theorists, Gary Becker (1996), in modeling the
behavior of utility maximizing economic agents.
For Gary Becker individuals are modeled as rational utility maximizers in the
sense that they are assumed to (Becker, 1996, p. 23): ‘‘. . . make forward-look-
ing maximizing, and consistent choices’’. What individuals maximize is rather
beside the point. In other words, an individualÕs utility might very well be maximized
in terms of altruistic, moralistic, or ethical behavior. What counts in BeckerÕs analyt-
ical framework is that individuals are rational given their objectives and the
constraints which they face when engaging in the decision making process. This
approach is referred to as present aim rationality. Although this framework is
consistent with the typical assumption made by economists that utility maximiz-
ing behavior is dominated by self-interest, it does not exclude behavior that is
dominated by the moral dimension. In other words, in BeckerÕs analytical world,
self-interest rationality is a subset of possible rational behavioral choices afforded
to individuals.4
A Becker style utility function can be written as follows:
U ¼ f ðQ; NM; EÞ; ð1Þ
where U is utility, Q is output or real income, NM is non-market time inclusive of
leisure and non-market work, and E is altruistic, ethical, or moral behavior. Q,
NM, and E yield utility in terms of the services that they generate to the individual.
Utility is maximized subject to the budget constraint of the economic agent. In this
model, more of E comes at the cost of the reduction in Q and NM necessary to in-
crease E. Therefore, there is a trade-off between Q, NM, and E. In other words,
behavior that is altruistic, moral, or ethical is not a free ride. There is an opportunity
cost involved. A central message of economic theory, including that of open-ended
economic theory, which allows for the moral dimension, is that one must make ex-
plicit the extent of the cost to the individual, and to society when externalities are
involved, of engaging in non-egotistic behavior. Eliminating E from consideration
does not bias economic analyses if E represents anomalous behavior. But the inter-
jection of E is required to explain anomalous behavior, more common economic
behavior that is dominated by the moral dimension, or differential behavior that is
4
This more open-ended view of self-interested behavior was clearly articulated by Hayek (1948) who
was well aware of how misleading the narrow definition can be. He writes (1948, 13): ‘‘The ÔselfÕ, for which
alone people are supposed to care, did as a matter of course include their family and friends; and it would
have made no difference to the argument if it had included anything for which people in fact did care’’.
Self-interest is related to what an individual thinks is desirable.
determined by individuals assigning differential weights to the moral dimension in

their respective utility function.
The opportunity cost of the moral dimension or the trade-off between income and
non-market time and the moral dimension can be illustrated using the standard eco-
nomic toolbox. In Fig. 1, real income and the quantity of moral acts are mapped out.
The slope of the income-moral acts line, Imax M, yields the trade-off between real in-
come and the number of moral acts. 0Imax represents the maximum income that an
individual can realize given her or his real wage and the maximum time available for
market activities. 0M0 represents the total number of moral acts that an individual
can achieve given the resources at hand. 0Imax can also be seen as a measure of net
real income, where net real income is a product of total real income discounted for
the value of moral acts done, such as tipping, charitable giving, or purchasing higher
priced commodities that are produced ethically such through environmentally
friendly production processes or in a safe work environment. The total amount of
charitable giving, for example, is limited by ones gross real income. At one extreme,
net income falls to zero, when the amount of charitable giving is at a maximum. 0Imin
is the minimum net income required by the individual for physiological or sociolog-
ical reasons. This sets a limit to the amount of moral acts that are technically feasi-
ble. The level of real income and the cost of each moral act jointly determine the
slope of the income-moral acts line. A standard indifference curve, such as I0, in com-
bination with the price line yields an equilibrium combination of net real and moral
acts at point E*. Given the indifference curve, the number of moral acts is given by
the position and the slope of the price line. In this model, it would be possible for no
moral acts to be undertaken, such as with a corner solution at point Imax, where the
individual in effect assigns a zero value to the utility generated by moral acts. In this
case, if an individualÕs target income increases with real income, no moral acts will be
I max C I*
Income
E*
I min I0 E’
E
I1
0 M0 M M’ B
Quantity of Moral Acts
Fig. 1. The income-moral dimension tradeoff.

undertaken no matter the level of real income. At the other extreme, an individual
might maximize utility at point E, where the individual assigns a heavy weight to
the utility generated by moral acts. If Imin, is the target income irrespective of the
level of real income, the number of moral acts will increase with increases in real in-
come. For example, in this case a shift in the budget constraint to AM 0 yields an
equilibrium increase in moral act to 0M 0 . Moreover, when income increases, the
number of moral acts increases as long as target income does not increase all the
way up to C. Finally, given preferences, the equilibrium quantity of moral acts pre-
ferred or demanded by the individuals is determined by the opportunity cost of mor-
al acts or by the price line. As with conventional economic theory, demand is
negatively affected by increasing opportunity costs and positively affected by dimin-
ishing costs.
This theoretical framework, which is consistent with the Becker world view (pres-
ent aim rationality), simply suggests the importance of opportunity costs to under-
taking moral acts and therefore how choices related to moral acts are affected by
income and the cost of carrying out moral acts. In this particular model, preferences,
as specified by the indifference curve, relating to moral acts are held constant and,
moreover, little attention is paid to differences in preferences across individuals. Indi-
vidual choice is determined by both opportunity costs and preferences. Holding
preferences constant, the equilibrium quantity of moral acts is determined by oppor-
tunity costs. Thus, there might be a certain quantum of moral acts that is function of
preferences given by the position and curvature of the indifference curve. This yields
what can be referred to as core moral acts, core acts of altruism, or core ethical
behavior. This might be small or large. Given preferences changes in preferred equi-
librium moral acts is a function of opportunity costs. The latter can be referred to
marginal moral acts, core moral acts, core acts of altruism, or core ethical behavior.
Ultimately, what an individualÕs choice is with respect to a particular mix of income
and moral act must be an empirical question. The axiom modest greed with regards
to the individual, referring to individualsÕ reluctance to make large material sacri-
fices, remains a testable hypothesis. Economic theory, speaking to the opportunity
costs involved in choices made by individuals, cannot itself speak to the type and size
of the trade-offs the typical individual is willing to make. But it does suggest that,
ceteris paribus, there is a negative relationship between the quantity of virtuous acts
undertaken and the related opportunity costs and that one would expect the quantity
of virtuous acts to increase as opportunity costs diminish. This is consistent with the
evidence from sociobiology on human altruistic behavior that individuals place close
attention to costs in their decision making (Singer, 2000; Trivers, 1971; Wilson, 1978,
2000).
Although the conventional wisdom, inclusive of Becker (Stigler & Becker, 1977),
rejects any focus on changing tastes as an independent variable, the Becker-style ana-
lytical framework is capable of integrating differences in tastes across individuals and
changing tastes as causal variables affecting the extent to which moral acts are pur-
sued (see also Becker, 1996). Different positions or slopes of the indifference curve
illustrate differences in tastes, whereas movements in the indifference curve or
changes in its slope, given the price line, illustrate changes in tastes. For example,
in Fig. 1 a movement from indifference curve I0 to I1 illustrates a change in tastes

such that an individual is willing to pursue more moral acts than previously given
an unchanging opportunity cost of so doing. The two indifference curves can also
illustrate different tastes or preferences between two individuals. This simple model
can therefore accommodate variables such as culture, education, the Ôwarm glowÕ ef-
fect, kinship, and reciprocity as determinants of the extent of and strength of pref-
erences favoring moral acts. In this model, for example, education that serves to
encourage individuals to give more to charity or to behave more honestly, where
both involve a sacrifice in real income, shifts the indifference curve from I0 to I1. Indi-
viduals are now willing to engage in more moral acts holding the opportunity cost of
so doing constant. Alternatively, individuals educated to be relatively more selfish
would engage in fewer moral acts, with this scenario illustrated by shifting the indif-
ference curve from I1 to I0.5 In this modeling of the individual the demand for moral
acts or moral–ethical products is affected by individual preferences and changes in
these preferences as well as by changes in the opportunity cost of such demand
and individualsÕ income level. This does not imply that education or cultural deter-
minants can result in completely self-sacrificing individuals or a blank-slate which
would be completely contrary to what we have come to know about human behav-
ior. Rather this modeling can account for the reality that, given opportunity costs,
education and more broadly culture can affect the extent of virtuous acts; what
can be referred to as moral acts, core moral acts, core acts of altruism, or core ethical
behavior (Mayr, 2001; Pinker, 2002; Ridley, 1996; Wilson, 1978, 1999, 2000). In an-
other vein, the extent to which moral acts yield good feeling or a warm glow (Andre-
oni, 1989, 1990), affects the position of the utility function. Related to the warm glow
affect is the affinity one feels to the recipient of moral acts – the evidence from socio-
biology strongly suggests that, ceteris paribus, virtuous behavior tends to increase
with the strength of the affinity one feels with the recipient. Thus affinity affects
the position of the indifference curve and changes in this variable shift the preference
function. In addition, the extent of reciprocity or expected reciprocity affects the po-
sition of the indifference and changes in this variable shift the curve.6
The Becker-style model developed in this article, where rational individuals max-
imize utility and where utility consists of both pecuniary and moral attributes, can
5
Frank, Gilovitch, and Regan (1993) make the case that standard neoclassical economics education
serves to shift preferences away from the pursuit of moral acts by advocating the view that only narrowly
selfish behavior is rational.
6
The sociobiology literature on altruism well recognizes that altruism, defined as helping others, can be
classified into altruism to offspring, to kin, to individuals in ones social group, and to ÔoutsidersÕ.
Individuals tend to impute the costs and benefits of helping others. Typically, self-sacrificing or hard core
altruism is reserved for those who are most closely related where material cost-benefit ratio can be quite
high. Ceteris paribus, as one moves towards outsiders this ratio must be much higher with expected or
immediate reciprocity being of increasing importance. Culture and education play an important role in
generating affinity between individuals who are not related genetically or even by immediate group
(ethnicity or race, for example), thus increasing the probability of altruistic acts (at higher cost-benefit
ratios) outside of the hard core (Bergstrom, 2002; Hirshleifer, 1978; Mayr, 2001, pp. 256–262; Trivers,
1971; Wilson, 1978, Chapter 7; Wilson, 2002).
allow for a variety of stylized facts that does not fit the narrow neoclassical model
that excludes the moral dimension from the utility maximizing framework. This
model allows for the following types of behavior that serve to reduce real income
or non-market time: tipping (Lynn, 2003, 2005); charitable donations (Andreoni,
1989, 1990; Sugden, 1984; Walker, 2002), paying higher prices for ethically consistent
products such as child labor free goods (Altman, 2000), ethical investments in firms
that may yield lower than average rates of return (Lewis & Webley, 1994; Lewis,
Webley, & Furnham, 1995; Mackenzie & Lewis, 1999), volunteering time that would
otherwise be devoted to self-interested activities, material sacrifices for the sake of
fairness as per ultimatum games (Guth, 1995), accepting lower salaries so as to en-
gage in morally or ethically uplifting jobs such as legal aid (Frank, 1996a, 1996b),
and differences in such activities across cultural spaces and educational regimes. It
warrants repeating that any moral acts that are expected to yield increasing material
returns are completely consistent with the narrow rational selfish utility maximizing
model critiqued by Etzioni and Frank, amongst others. But what remains a funda-
mental question is the extent of sacrifice the typical individual is willing to make so as
to behave altruistically, ethically, or morally, when there are no increasing returns to
such behaviors. How big a shadow does the moral dimension cast over the behavior
of the typical individual? To address this question one must recognize that virtuous
behavior can be utility enhancing and that modeling moral behavior requires open-
ing up the conventional economic model to incorporate the fact that individuals tend
to be self-interested, are affected by opportunity costs, the utility or warm flow of
being virtuous, the extent of affinity with the recipients of moral acts, the extent
of reciprocity, education, culture (norms), and information, where the latter can
affect the other variables. In this more general model, rational self-interested individ-
uals can be expected to behave virtuously or not depending upon a host of well-
defined circumstances. A fatal flaw of the simple economic model is its focuses on
the opportunity costs of moral behavior to the exclusion of other important vari-
ables which affect human behavior.
Ultimately, the important research that unequivocally demonstrates that there is a
moral dimension to the economic agent and that the economic agent might be willing
to trade off moral acts for material and related personal benefits has not challenged
the theoretical infrastructure of the conventional neoclassical economic wisdom be-
cause the moral dimension can easily be incorporated into a utility maximizing
framework. This is spite of the fact the so many economists have refused to do so.
However, such behavior can be integrated into conventional economic modeling
only if the consequences of self-sacrificing moral acts do not impinge on the compet-
itive position of firms. For example, making charitable donations reduces the giverÕs
net real income, but this moral act does not affect the competitive position of the
giver. On the other, if an ethical firm engages in practices that increase unit produc-
tion costs, such moral acts make the ethical firm uncompetitive and, therefore,
economically unviable, unless consumers are willing to pay a higher price for ethi-
cally produced goods. In effect, individuals can choose to behave as they will as
long as their survival on the market cannot force them to behave in one particular
fashion or another. To assume that individuals must always behave in a narrowly
self-interested manner, presumes that moral behavior is inconsistent with individu-

alsÕ utility maximizing efforts, even when such behavior is unrelated to market activ-
ities or does not reduce the competitiveness of the individual on the market.
What the conventional economic wisdom predicts is that altruistic, ethical, or
moral behavior that is inconsistent, in their results, with competitive market forces
cannot persist over time unless they are somehow afforded protection from such
market forces. In this case, one would not expect ethical firms to survive on the
market place if producing ethically yields relatively high unit costs as compared to
firms producing the same product. A basic premise of the conventional neoclassical
wisdom is that narrowly self-interested behavior is a precondition of firms surviv-
ing on the market place. Market forces induce individuals to behave in this man-
ner since only such self-interested behavior is consistent with their firmsÕ long
term survival on the market place. In other words, narrowly self-interested behavior
is the behavior that is most consistent with cost minimization on the part of the
firm. This type of argument is found in FriedmanÕs classic articulation of the Sur-
vival Principle (1953; see also Reder 1982; Altman 1999). In this case, choosing a
moral act has consequences that cannot be tolerated on the free competitive market
place and, therefore, a moral dimension to the economic agent cannot exist in a com-
petitive market economy. But we are then presented with the apparent paradox of
the simultaneous existence of moral or ethical and immoral or unethical firms pro-
ducing over the long run in the same product market. If moral acts generate higher
unit costs, ethical or moral firms should not exist. Yet, if ethical and moral firms are
cost efficient, all firms should behave ethically or morally for reasons of survival in
the competitive market. In this case, there would be a moral imperative facing all
firms in a competitive market (Dalla Costa, 1998).7 Otherwise, we should expect
to find the relatively high cost firms existing only in protected economic
environments.
3. The ethical–moral firm in production
A moral or ethical firm is one that engages in practices such as implementing

superior health, safety, and work standards, banning the use of child labor, produc-
ing in a relatively environmentally friendly manner, producing safe products, and
testing products in an ethical fashion. The conventional neoclassical economic wis-
dom analytical predicts that firms producing in this manner will produce at a higher
unit cost. This analytical prediction has gone largely unquestioned even in much of
the non-conventional literature dealing with the moral dimension of the economic
agent (Frank, 1996a, 1996b, 2004; Kapstein, 2001; Lewis & Webley, 1994; Lewis
7
Dalla Costa (1998) and Petrick and Quinn (1997) argue that ethical and moral acts by firms yield
significant material benefits implying that such benefits exceed any costs associated with the realization of
relatively more ethical and moral behavior. This begs the question as to why all firms are not ethical or
moral or, at least, in the process of becoming more ethical. These authors also elaborate upon the
economic and social costs incurred by unethical and immoral behavior by firms.
et al., 1995; Mackenzie & Lewis, 1999; Tomer, 1994; Warneryd & Lewis, 1994).8
Ethical or moral acts can be modeled, from this perspective, as an additional output
that might be produced jointly with the traditional output such as clothing or auto-
mobiles. Alternatively, ethical or moral acts can be viewed as producing a different
quality of product. The additional output or different quality of product requires
more inputs. This, in turn, yields a higher unit cost since the only output that is part
of the calculation is the amount of cloth or the number of cars produced which is not
affected, in the conventional neoclassical world view, by ethical or moral behavior by
the firm. In this case, ethical or moral firms should not survive in a competitive mar-
ket. These high cost firms can survive only in a protected environment or when a spe-
cific demand exists for the higher cost and priced ethical products. In either case, this
translates into an opportunity cost of less goods and services per capita in an ethical
or moral economy. However, ethical or moral firms need not be cost inefficient or are
only so under very specific assumptions. Applying a behavioral model of the firm
developed elsewhere (Altman, 1996, 2001b), to the ethical and moral firm, it can
be demonstrated that the logic of the conventional wisdom applies only to a world
where the firm is perfectly efficient from the start, which is a very special case. Other-
wise, when ethical and moral acts contribute to the productivity of the firm, ethical
or moral firms need not generate higher unit costs or lower profits. It is shown, that
both ethical and unethical firms can produce at the same unit cost and rate of return.
The behavioral model of the firm presented here resolves the perceived paradox of
the simultaneous existence of ethical and unethical firms in the same competitive
product market. Moreover, according to the behavioral model there need not be
an opportunity cost for ethical firm behavior in terms of less goods and services
per capita.
The neoclassical firm is one where firms are producing as efficiently as possible
given the objective constraints that they face, inclusive of transaction and informa-
tion costs (Stigler, 1946, 1976). In effect, they are operating along the production
possibility frontier and exhausting all known opportunities for gain and, therefore,
the economic agents within the firm are behaving consistently with the Axiom of
Modest Greed. In so doing firms are maximizing output per unit of input. More spe-
cifically it is assumed that economic agents are maximizing effort per unit of input in
the sense of working as hard and well as they can. Firms are effectively forced to be-
have in this fashion so as to survive in a competitive market – FriedmanÕs survival
principle. To the extent that ethical or moral behavior requires additional inputs into
the process of production, the already efficient firm will simply be facing higher costs,
8
Basing themselves on efficiency wage theory, Fehr and Schmidt (1999) and Fehr and Gachter (2000)
argue that a certain degree of ethical behavior in terms of fairness and reciprocity can be expected to exist
in the firm in equilibrium. This includes firms paying workers relatively high wages. Workers induce firms
to pay high wages through their capacity to withdraw effort if they are paid a too low (unfair) wage. As per
the efficiency wage literature, this generates a relatively high wage (above the competitive market clearing
wage) that is profitable and cost minimizing for the firm to pay. However, this finding, based on the
experimental literature, begs the question as to why firms do not tend to voluntarily devolve into high
wage firms. See Field (2001) for a discussion of the reciprocity inclined literature.
and will be unable to compete in a competitive market. The neoclassical model as-
sumes that ethical or moral behavior does not positively affect the efficiency of the
firm since the firm is assumed to be operating at maximum efficiency from the start.
Building upon and extending the literature on efficiency wage (Akerlof & Yellen,
1990; Stigler, 1987) and x-efficiency theory (Frantz, 1997; Leibenstein, 1966, 1979),
the behavioral model of the firm assumes that firms are not necessarily producing effi-
ciently (Altman, 1996, 2001b, 2002). In this case, effort need not be maximized per
unit of input and the firm is operating inside of the production possibility frontier.
Leibenstein (1966, 1979) refers to this type of inefficiency in production, based on
the sub-optimal performance of labor inputs, as x-inefficiency. In the behavioral
model of the firm the quantity and quality of effort is a discretionary variable and,
therefore, labor productivity is not simply a function of capital per worker or techno-
logical change. For effort to be a discretionary variable, the marginal transaction costs
of metering, monitoring, enforcing, and writing effort-specific contracts must exceed
the marginal benefits for both managers managing the effort inputs of workers and
owners managing the efforts inputs of managers. Once effort is discretionary, efficient
production requires certain conditions be met, internal to the firm, which are indepen-
dent of external market forces. Specifically, indirect incentives must be developed to
ensure that the quantity and quality of effort inputs are maximized. Moreover, market
forces, no matter how competitive, need not impose such conditions upon the firm.
There is a growing literature which suggests that only in more trusting cooperative
based forms of industrial organization, is effort per unit of labor input maximized
(Alcaly, 1997; Altman, 1996, 2001b, 2002; Gordon, 1996; Ichniowski, Kochan, Le-
vine, Olson, & Strauss, 1996; King, 1995; Levine & Tyson, 1990; Miller, 1992; Pfef-
fer, 1995; Tomer, 1999). Such a system of industrial relations can also be referred to
as one that is driven by ethical or moral norms (Dalla Costa, 1998; Tomer, 1999).
Under such a system of industrial relations, labor has a direct and meaningful input
into the decision making process, labor compensation is related in part to productiv-
ity, there is relative job security, and there is a relatively less hierarchical administra-
tive structure. Labor productivity can be expected to be below the maximum unless
the firm adopts a more cooperative system of industrial relations. For this reason, in
the behavioral model of the firm unit costs are, in part, affected by effort per unit of
labor since this variable, since unlike in the conventional model, effort per unit of
labor varies thereby impacting upon labor productivity. The same literature that ar-
gues for a positive relationship between productivity and work culture also posit that
establishing a relatively cooperative work environment is costly. To become more
productive or x-efficient requires the firm investing in what Tomer (1987) refers to
as organizational capital. This includes, improved screening and training of employ-
ees and managers and redesigning and reconfiguring the shop floor for a more par-
ticipatory work environment. Members of the firm hierarchy would also have to
work harder and smarter. In additional to organization capital the firm would also
have to invest in higher wages to their employees. In the behavioral model of the
firm, therefore, there are two intimately related dimensions to becoming more x-effi-
cient. One dimension speaks to increasing productivity whereas the other speaks to
increasing costs.
The difference in the relationship between the conventional and behavioral model
is specified in the following production function:
e
Q ¼ L; K; ; T ; ð2Þ
t
where Q is output, L is labor input per unit of time, et, T is technology. In the con-
ventional model, et is assumed to be maximized and, therefore, production is assumed
to be x-efficient whereas in the behavior model et is a function to the wage rate and the
quantity and quality of organization capital in the firm. Also, in the conventional
model technology is assumed to be exogenous whereas in the behavioral model tech-
nology is assumed to be endogenous, a partial function of the wage rate and the
organizational capital of the firm. The importance of technological change to the
ethical or moral firm will be discussed below. At this point, to isolate the determi-
nants of efficiency, technology is assumed to be a constant in the model.
The significance of the effort variability for the firmÕs unit costs is specified by the
following average cost equation, where, for simplicity, a world where the only costs
of production relate to labor and organizational capital is assumed:
OCL L þ wL
AC ¼ ; ð3Þ
Q
where AC is average costs; OCL is the value of organizational capital per unit of
labor input; w is rate of labor compensation; L is labor input; and Q is output. This
equation can be rewritten as:
OCL w
AC ¼ Q
þ Q
. ð4Þ
L L
It is assumed that QL is a positive function of et which, in turn, is a positive function of

w and OCLL. Ceteris paribus, QL is maximized when et is maximized. In this case, aver-
age cost would be minimized. In the conventional model, of course assumes et that is
always at a maximum. But, ceteris paribus, in a world of x-inefficiency, where et is not
maximized, average or unit costs are greater than they need be. In LeibensteinÕs
(1966) classic formulation of x-efficiency theory, x-inefficient firms are relatively high
cost producers who require protection in the form of a monopolistic market struc-
ture, tariffs, or subsidies. X-inefficient would not be able to survive in a competitive
environment against relatively x-efficient firms. Therefore, in competitive equilib-
rium, all firms must be x-efficient.
In the behavioral model of the firm (Altman, 1996, 2001b), in contrast to the clas-
sic x-efficiency model, the relationship between the level of x-efficiency and the cost
of achieving a particular level of x-efficiency is recognized. Once this done, it be-
comes evident from Eq. (3) that x-inefficient firms can remain cost competitive as
long as low levels of x-efficiency are related to low rates of labor compensation
and low levels of organizational capital. Low rates of labor compensation and a poor
work environment serve as substitutes for a monopolistic market structure, subsidies
or tariffs, protecting x-inefficient firms from their more x-efficient competitors. Alter-
natively, high wage firms combined with relatively high level of organizational
capital, which, itself, might include relatively high levels of ethical behavior, can re-
main competitive by becoming relatively x-efficient. For example, improving the
health and safety standards within the firm need not transform the firm into a more
costly producer if higher levels of x-efficiency compensate for these improvements. In
other words, x-efficient and x-inefficient firms can both survive simultaneously in
competitive equilibrium if they both produce at the same level of cost and high
and low wage and organizational capital intensive firms can both survive simulta-
neously in competitive equilibrium if they both function at offsetting differential lev-
els of x-efficiency. In fact, it would be possible for there to exist in competitive
equilibrium an array of firms characterized by different wage rates and levels of orga-
nizational capital producing at an identical unit cost if these differentials are compen-
sated for by differential in the levels of x-efficiency. In this case, some linearity in the
relationship between working conditions, effort, and productivity is assumed (Aker-
lof & Yellen, 1990; Altman, 1996; Stiglitz, 1987). Moreover, in this scenario, there is
no incentive for firm managers or owners to make their firms relatively x-efficient if
this has no impact on unit costs. In the behavioral model, members of the firm hier-
archy can be expected to be indifferent between x-efficient and x-inefficient forms of
production from the perspective of unit costs. This would be true even for firm deci-
sion makers comprising of owners and managers who are rational profit maximizing
in the traditional neoclassical sense, since there is no material advantage to be gained
from producing x-efficiently. In other words, no material sacrifice is being made on
the part of members of the firm hierarchy.9
This argument, applied to the moral or ethical firm, is illustrated in Fig. 2, where
ethical behavior is mapped out along the horizontal axis and average costs along the
vertical axis. It is assumed, following from the literature, that various aspects of eth-
ical or moral behavior within the firm are tied to the rate of labor compensation and
to components of the firmÕs organizational capital. In this sense, the ethical firm can
be expected to be relatively more x-efficient, but also more costly to operate. On the
other hand, the less ethical firm is less productive, but less costly to operate. In addi-
tion, although other aspects of ethical behavior such as producing in a more environ-
mentally friendly manner or banning the use of child labor serve to increase costs
without directly impacting on the level of x-efficiency, such moral behavior might in-
duce more x-efficient behavior for the firm to survive in a competitive market (Alt-
man, 2000, 2001b). Needless to say, firms operating at various levels of ethics or
morality can be expected to produce at the same unit cost if a higher level of produc-
tivity (x-efficiency) compensates for the economic costliness of being ethical, and vise
versa. Along 0E*, is firms operating at different levels of ethical behavior produce at
the same unit costs. In this case, differences in productivity just compensates for the
economic cost associated with the firm adopting relatively ethical or moral norms
in terms of the production process. Past point E*, improvements in the level of
9
Because Milton Friedman accepts the notion that ethical products comes at significant economic costs,
he argues that efforts to enforce such modes of production upon firms, especially in the poorer parts of the
world can cause serious economic harm to the worldÕs poor. In other words, given this methodological
perspective, unethical production, broadly defined, might be more beneficial to the worldÕs poor.
Unit costs
Average Cost
Conventional model
C* Behavioral model
0 E*
Level of Ethical behavior
Fig. 2. The ethical firm.
x-efficiency no longer suffice to compensate for higher levels of ethical behavior. This
results in higher unit costs. In contrast, in line with the conventional neoclassical
model, where firms are producing x-efficiently from the get-go, unit costs increase
with increases in the level of ethical behavior where such behavior has a positive eco-
nomic cost attached to it. This is so since, by assumption, firms cannot increase their
level of efficiency to compensate for the cost of becoming more ethical. In the behav-
ioral model, firms have that additional degree of freedom to adopt more ethical
norms into their production process, even in the most competitive of product market
environments, since unit costs need not rise as a direct byproduct of becoming more
ethical. Behaving ethically in production becomes much more of an option in a com-
petitive environment from the perspective of the behavioral model of the firm pre-
sented here.
Introducing technical change into the behavioral model of the firm strengthens
these results by affording firms yet an additional degree of freedom in the longer
run to adopt more ethical or moral behavioral in the process of production. Building
upon a behavioral model of economic growth developed elsewhere (Altman, 1996,
Chapter 4) which, in turn, follows in the tradition of induced technical change estab-
lished by Habbakkuk (1962), Hicks (1932), and Ruttan (1997), I assume that changes
in factor prices and in relative factor prices affect the pace and the path of techno-
logical change. Moreover, in the tradition of Harvey Leibenstein (1973), I assume
that the pace of technical change is affected by the level of x-inefficiency existing
and expected to exist in the firm. As in the above discussion, perfect product markets
and rational profit maximizing firms are assumed.
The potential impact of introducing or increasing ethical or moral behavior on
firm costs is illustrated in Fig. 3, where capital and labor are the two factor inputs
yielding both marketed output and ethical and moral acts. The initial equilibrium
for marketed output is given by point A along isoquant Q1. More ethical behavior
requires more capital and labor, which is illustrated by a shift outward of the budget
or isocost line from B 0 C 0 to BC and of the isoquant from Q1 to Q0, where the level of
B’
2
B’’
1
Capital
A* E
A
A’’ A’
Q0
Q1
Q3 Q2
0 C’’’ C’’ C’ C
Labor
Fig. 3. Technological change and ethical behavior.
output at Q1 is Q0 and equal. The new equilibrium is given by point E along Q0.
Being increasingly ethical, therefore, increases average costs, as more expenditure
is required to produce a given level of output. For average cost to remain unchanged
in the ethical firm requires a reduction in the level of x-inefficiency (discussed above)
or technical change such that the isoquant shifts from Q0 to Q1, where output at Q1
and Q0 is equal. In this case, unit costs need not increase if increasingly ethical
behavior induces a sufficient amount of technical change. It is important to note that
since such ethical behavior is a prerequisite to this particular instance of technical
change, the less ethical firm could not adopt the new technology. It is also important
to appreciate that such improvements in productivity typically require and go hand
and hand with improving the conditions of labor, resulting in increasing the relative
price of labor, increasing the slope of the isocost line from B 0 C 0 to B 0 C00 . Without
further technological change and or further reductions in the level of x-inefficiency,
the profit maximizing firm will adjust its input combination along ray 2, at A* along
isoquant Q2, so as to minimize unit cost. To produce the initial level of output given
by isoquant Q1 translates into producing marketed output, now in a more ethical
fashion, at a higher unit cost – the isocost curves shifts outward. However, these
expected or realized increased cost stemming from more ethical behavior might in-
duce the necessary further technological change, shifting the isoquant from Q0 to
Q1, where the level of output at Q0 to Q1 are equal. The firm could then produce the
original level of output at the original unit cost since isocost curves B 0 C 0 and BC rep-
resent the identical level of expenditure. The technological changes and reductions in
the level of x-inefficiency are discussed here sequentially for illustrative purposes only
and can be expected to take place simultaneously in response to the cost increases
flowing from behaving more ethically in the process of production.
In this scenario, the relatively ethical firm produces its marketed output at the
same unit cost as the relatively unethical firm once technological change is intro-
duced into the equation. The relatively unethical firm, therefore, has no incentive
to adopt the new technology if the new technology yields no unit cost advantage
to the firm and if the unethical firm remains cost competitive and profitable using
the old technology. Moreover, the old and new technologies are linked to specific
and differential costs related to the level of ethical behavior within the firm. In other
words, to adopt the new technology involves an avoidable investment in time, effort,
and capital. For this reason, there would be no economic imperative, for firms to be-
come ethical, unless the preferences of the firmsÕ decision makers or regulation drive
them in this direction. Firm decision makers would not be forsaking economic gain
by not adopting the new ethically intensive technology. Only if the relatively ethical
firms developed even more advanced technology given by a shift in the isoquant
from Q2 to Q3, where the quantity of output at Q2 equals that at Q3 and where
the isocost curve shifts inward from B 0 C00 to B00 C000 , would the unit costs of the ethical
firm drop below that of the relatively unethical firm. In this case, market forces
induce the relatively unethical firms to become more ethical.
The behavioral model of the firm stipulates those conditions under which choos-
ing to behave ethically or morally in the process of production remains consistent
with the survival principle. As long as the firm can compensate for the increased cost
of being ethical by reducing the level of x-inefficiency or by adopting or developing
new technology, the ethical firmÕs unit cost need not rise relative to that of the rela-
tively unethical firm. In this case, competitive market forces do not preclude the
firmÕs decision makers choosing to become more ethical. This would be true, for
example, for firms adopting a more worker-friendly shop environment, regulating
or eliminating child labor, or regulating the production of pollutants associated with
production (Altman, 2002, 2000, 2001c, 2001a). The conventional neoclassical mod-
eling of the firm, by assuming that firms are operating x-efficiently independently of
the work environment or industrial relations system within firms and of the ethical or
moral structure of firms, necessarily predicts that changing behavior or changing the
method of production incurs higher unit costs. In the behavioral model, situated in a
world of rational profit maximizing economic agents, effort discretion, and induced
technical change, allows for the simultaneous existence in a perfectly competitive
market environment of both ethical and unethical firms. But since the ethical firm
is not a construct of an economic imperative, one cannot expect that ethical firms
will dominate in the free market unless firm decision makers preferences shift to-
wards the ethical firm. Since firm decision makers in the dominant hierarchical firm
do not necessarily materially benefit from transforming the firm into a more ethical
entity – employees are the most direct beneficiaries – there is no immediate economic
incentive for firms to become ethical. This speaks to the importance of education and
government regulation in determining the extent to which the ethical firm becomes
the dominant organizational form in the market economy.
4. The ethical–moral firm and the structure of demand10
Although the ethical firm can be cost competitive and choosing the ethical route
to firm development is not precluded by market forces, as predicted by the conven-
tional wisdom, ethical firms can also remain cost competitive and profitable even if
they yield higher unit costs producing the same product. This argument is consistent
with conventional economic wisdom, although it is rarely articulated. Assume for
simplicity that all firms are characterized by the same production function and that
each set of firms producing the same product is characterized by constant returns to
scale, so that market size does not affect unit costs. Ethical firms producing a parti-
cular product, such a specific type of cloth, are not producing the same cloth as
unethical firms. Even if the product is identical in all other characteristics this same
product can be differentiated by the extent to which is it produced in accordance to a
specified set of ethical standards. An ethically produced red cotton cloth is different
from one produced unethically, and will be treated as such by consumers. And, so
argues Freeman (1994), in his discussion of the use of child labor in the process of
production. This argument can be extended, as an example, to the production of pol-
lution-intensive products, ÔnaturallyÕ produced fruits and vegetables, and products
produced in firms bound by high health and safety standards. In this case, even if
the ethical product is produced at a higher unit cost, as predicted by the conventional
economic wisdom, consumers may still purchase this product if that product is
clearly and reliably labeled. Operationally, what becomes critical here is the capacity
and ability to determine what an ethical firm is, and to provide for effective well-rec-
ognized labeling of such firms. On the other side of the coin, is the capacity and will-
ingness of consumers to purchase the higher priced ethical products.
When the ethical content of the product affects unit costs, the survival of the eth-
ical firm hinges upon the structure of demand and, more specifically, upon the struc-
ture of consumer preferences with regards to the ethical content of marketed output.
If all consumers prefer the ethically intensive products, these will be the only prod-
ucts produced. On the other hand, if consumers prefer the output of the relatively
unethical firms (in part for reasons of affordability), the relatively unethical firms
dominate. Those relatively ethical high cost firms that do survive as a consequence
of the structure of the demand would be profitable in the sense that long run average
cost equals price. The same would be true of their relatively unethical low cost
counterparts. In this case, there would be no reason to expect the ethical firms
to yield a low rate of return than the relatively unethical firms. However, in this
10
See Kahneman et al. (1986a) and Kahneman et al. (1986b), for a detailed discussion of the role played
by perceptions about fairness in determining the price elasticity of demand.
scenario, consumers face a clear trade-off when deciding to purchase the same prod-
uct from an ethical or an unethical firm. The purchaser, of the ethically intensive
products suffers a fall in real income since more income must be disbursed to pur-
chase the ethically intensive product. Such opportunity costs are illustrated in Fig. 1.
What drives the sustainability of relatively high cost ethical firms is then the
opportunity cost of purchasing ethical products, the income of consumers, and their
preferences. Assuming, identical incomes across all consumers, the demand for eth-
ical products is a product of the preferences of consumers and the level of income
relative to target income. In Fig. 1, given target income of Imin, the income level
given by Imax M is high enough to allow individuals to purchase high priced ethical
products or engage in costly moral acts. In this case, it is the preferences of consum-
ers and their capacity to identify ethical products that determines the level of demand
for ethical products. Where income is so low that individuals cannot afford to pur-
chase ethical products, ethical products will not be purchased. More dynamically, as
income drops towards the level of target income, the demand for ethical products
falls. On the other hand, given preferences, the level of target income, and the rela-
tive price of ethical products, as income increases, for example to AB, the demand
for ethical products will increase. As income increases, consumers can actualize their
preferences for ethical products, which at lower levels of income they could not af-
ford to do. Still as income increases, if individuals develop a taste for more commod-
ities, their target income rises and individuals might still not purchase ethical
products. Thus preferences play a determining role, given the level of income and
the opportunity cost of purchasing ethical products, in establishing the demand
for ethical products.
One illustration of the demand side for ethically and unethically produced prod-
ucts is presented in Fig. 4. S0 and Se is the supply of unethically and ethically pro-
duced products respectively. Se lies above S0 if it is assumed that it is more costly to
produce a product ethically. Given a product demand curve of D0, there can be a
demand for both unethically and ethically produced commodities. Points along
D0, above point a, represent individuals willing to purchase a product at price P1
and above. Therefore, at this price there can be a demand for ethical products of
0E0. In this case, the demand for unethically produced products would E0NE0.
Any decrease in the cost of producing ethically, given by a shift outward of supply
curve Se, will result in more ethically produced products being purchased and fewer
unethically produced products being bought. On the other hand an increase in in-
come would shift the product demand curve outward to D1. Given preferences, this
yields an increase in the demand for both ethically and unethically produced output
at 0E1 and E1NE1 respectively. It is possible that the increase in income yields no in-
crease in the demand for the unethically produced output, given by demand curve
D2. In this case, the unethically produced output is an inferior good. All told, there
is no reason for relatively high priced ethically produced output to be uncompetitive
if there are individuals willing to incur the opportunity cost of purchasing such
output.
The structure of demand might also play an important role in determining the sig-
nificance of the ethical firm in the economy even if, as suggested by the behavioral
D2 Se
Price
D1
D0 d
P2
S0
a
P1
c
b
P0
0 E0 E1 NE0 NE1
Supply
Fig. 4. The ethical market.
model, the ethical firm need not produce at a higher cost than the relatively unethical
firm. Under these circumstances, effective and reliable labeling allows consumers to
select the ethically intensive product at no cost to themselves if they so desire. Unless
there exists an unwavering preference for products produced by the relatively uneth-
ical firms, even when there is no cost advantage in so doing, the demand for their
products should fall off at least somewhat resulting in increasing the relative impor-
tance of ethical firms. If preferences are such that the typical individual prefers and
would demand ethical over non-ethical products when there is no cost disadvantage
in so doing, effective and reliable labeling would contribute towards the dominance
of ethical firms. Therefore, the structure of demand can play a determining role in
the significance of ethical or moral firms in the economy when such firms are cost
competitive with their relatively unethical counterparts. In addition, in this scenario,
as in the case when ethical firms are the high cost producers, labeling plays a critical
role in determining the structure of demand and thereby the significance of ethical
firms in the economy.
5. Conclusion
The moral dimension of the economic agent, although long neglected by most
economists, does not lie beyond the realm or capacity of economic theory. Indeed,
economic theory, broadly defined, can serve to enrich our understanding of the dy-
namic and dialectic interrelationship between the moral dimension and the economy.
Conventional neoclassical economic theory can easily accommodate altruistic,

ethical, and moral behavior as part of its standard rational agent utility maximiz-
ing framework, when such behavior has no impact on the survival of the firm. In
this case, economic theory serves to specify the opportunity costs involved in engag-
ing in such behavior. The extent of altruistic, ethical, and moral behavior simply
depends on the preferences of individuals, given the economic constraints. For
this reason, that such behavior has been marginalized by mainstream economists
has little to do with the fundamentals of the rational utility maximizing frame-
work of neoclassical theory. Rather it is often assumed, ex ante, that individuals
are constrained to behave in a narrowly selfish manner. Deviations from this type
of behavior are assumed to be sub-optimal or irrational in spite of the fact that altru-
istic, ethical, and moral behavior can be quite consistent with an individualÕs prefer-
ences. Needless to say, the narrow economic model need be broadened to
incorporate the variety of variables which affect the extent of virtuous behavior
which include opportunity cost as well as, for example, education, culture, affinity
to the recipient of virtuous acts, and reciprocity. What lingers in the background
is the sense that such behaviors cannot persist for they are assumed to be inconsistent
with the survival of the firm even when such behaviors are not related to the eco-
nomic performance of the firm. Once this false premise is thrust aside for individual
behavior not subject to market pressures, the door is open to determine the impor-
tance of altruistic, ethical, and moral behavior to individual utility maximizing
choices and the specification of the potential opportunity costs involved in engaging
in such behaviors.
However, even when altruistic, ethical, and moral behavior is firm-based, the con-
ventional economic wisdomÕs analytical prediction that such behaviors are unsus-
tainable need not hold. The conventional wisdom is built upon very narrow
behavioral assumptions that invariably causally link altruistic, ethical and moral
behavior within the firm with higher and uncompetitive unit production costs. A
behavioral model of the firm is introduced in this paper that specifies the conditions
under which such behaviors cause no increase in unit costs and, moreover, have a
positive impact on productivity. In this case, the ethical firm is not only sustainable,
contrary to the conventional wisdom, but adds to the material well-being of society.
Additionally, there is no reason to expect, based on the fundamentals of the firm,
that such ethical firms should yield low rates of return to ethical investors, in ethical
mutual funds for example. But if the ethical firms are simply competitive with the
unethical firms and visa versa, market forces will neither drive out the ethical or
the unethical firms.
When altruistic, ethical, or moral behavior inside the firm neither damages nor ad-
vances the competitive position of the firm, as can be the case according to the
behavioral model of the firm, there exists no economic imperative that force firms
to become either more or less ethical. Under these circumstances, whether or not
the ethical firms dominate the market depends on the preferences of individuals; that
is on the demand side of the market. Individuals who prefer the products of the eth-
ical firms will purchase only the output of the ethical firms if this output is priced no
higher than same output produced by the unethical firms. The more such individuals,
the more dominant the ethical firms will be. But for this preference to be exercised,
the output of the ethical firms must be properly identified. The importance of indi-
vidual preferences also comes to the fore when investigating the sustainability of the
high cost ethical firms. Even such relatively high cost firms are sustainable and prof-
itable if there is a market for the relatively high priced output of these firms. In this
case however, as opposed to the situation where ethical and unethical firms produce
at the same unit cost, there is an opportunity cost incurred by the consumers of eth-
ically intensive products. This reduces the probability of the ethical firms becoming
the dominant organizational form as opposed to the scenario specified by the behav-
ioral model wherein both the ethical and unethical firm can produce at the same unit
cost. Nevertheless, to the extent that higher unit cost ethical firms are competitive
given the demand side of the equation, such firms need not yield low rates of return
than either the lower cost ethical firms or the lower cost unethical firms. Thus, both
high cost and low cost ethical firms, based on the fundamentals of the firm can yield
competitive rates of return. An appreciation of the impact of preferences on the sur-
vivability of firms and of the potential positive impact of the moral dimension on
firm productivity serves to provide us with better a understanding of the additional
degrees of freedom afforded to economic agents, even in the most competitive econ-
omies, to increase the level of altruistic, ethical, and moral behavior inside the firm.
Ethical producers need not be driven out of the market place and ethical investors
need not be incurring an opportunity cost in realizing their preferences for ethical
investing.
Acknowledgments
The author thanks two anonymous referees, Louise Lamontagne, Elias Khalil,
Catherine Walker, as well as participants of the SABE/The Allied Social Science
Association Meetings, January, 2000, Boston; the Department of Economics Visiting
Speakers Seminar, University of Winnipeg, March, 2000; the IAREP-SABE Meet-
ings, Baden-Vienna, July, 2000; and the Association for Social Economics Meetings,
Cambridge University, Cambridge, August 2000; the Department of Economics
Distinguished Visiting Speakers Seminar, Lasalle University, Philidelphia, March,
2001; the Jorn Templeton Freedom Project Lecture, Stetson University, DeLand,
Florida, April 2001; the Department of Economics Visiting Speaker Seminar, Wake
Forest University, Winston-Salem, North Carolina, May, 2001, Eastern Economic
Association Meetings, Boston, February 2002, Second Annual Symposium on the
Foundation of the Behavioral Sciences, Behavioral Economics and Neoclassical
Economics: Continuity or Discontinuity?, Behavioral Research Council, A Division
of American Institute for Economic Research, SimonÕs Rock College of the Bard,
Great Barrington, MA, July 19–21, 2002, International Association for Research
in Economic Psychology Conference, Christchurch New Zealand, September,
2003, Department of Economics Seminar, Augustana University College, Camrose,
Alberta, March, 2004, for their insightful comments and suggestions. The standard
caveat applies.
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Journal of Economic Psychology 26 (2005) 732–757

The ethical economy and competitive

Available online 15 July 2005

JEL classiﬁcation: B4; D2; J5; L1; L2

PsycINFO classiﬁcation: 2630; 2900; 3000; 3900; 3660

Keywords: Altruism; Ethical; Behavioral; Rational; Demand

One seemingly poignant critique of contemporary economic theory is that it has

2. The altruistic individual

determined by individuals assigning diﬀerential weights to the moral dimension in

Quantity of Moral Acts

Fig. 1. The income-moral dimension tradeoﬀ.

in Fig. 1 a movement from indiﬀerence curve I0 to I1 illustrates a change in tastes

self-interested manner, presumes that moral behavior is inconsistent with individu-

3. The ethical–moral ﬁrm in production

A moral or ethical ﬁrm is one that engages in practices such as implementing

It is assumed that QL is a positive function of et which, in turn, is a positive function of

Fig. 2. The ethical ﬁrm.

Fig. 3. Technological change and ethical behavior.

4. The ethical–moral ﬁrm and the structure of demand10

Fig. 4. The ethical market.

Conventional neoclassical economic theory can easily accommodate altruistic,

Freeman, R. B. (1994). A Hard-headed look at Labour Standards. In W. Sengenberger & D. Campbell

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