Thursday, January 26, 2012

Cost-Benefit Analysis and Business Ethics

For my undergraduate thesis in economics, I chose to write about cost-benefit analysis and its discontents. Cost-benefit analysis, or CBA, refers to any process whereby the monetary costs of pursuing some particular course of action are weighed against the monetary benefits in order to decide whether that course of action is "worth" pursuing. In my thesis I argued that, for one thing, many public goods such as clean air and safe working environments are not monetizable and that to value these things in terms of money is unjustifiable, since the value of not being killed on the job or being able to breathe the air is more than just monetary. Not everyone agrees with the assertion that not all things can be valued in terms of money. In fact, most of the important policy makers in this country would seem to disagree. I'll leave aside that aspect of CBA though, and focus on a less controviersial application of cost-benefit accounting.

So let's say we have a firm. Like all firms, the management in dedicated to maximizing share-holder value, which translates as maximizing revenue and profits. Now, let's say that a regulation is passed requiring the firm to reduce it's toxic waste output, since the pollution is causing cancer and birth-defects in a nearby town. The question for the firm is whether or not to comply with the regulation. Both complying and not complying might entail monetary costs and minimizing these costs is the job of the CBA analyst.

The costs of complying with the reg might include things like new equipment to filter discharge and increased labor costs to install and maintain the filters. The costs of not complying with the reg would include fines from the regulatory agency and lawsuits and/or settlements with injured residents. Cost-benefit analysis tells us that if the costs of complying are more than the expected cost of non-compliance, then we should ignore the regulation. If, on the other hand, the expected costs of fines and lawsuits outweigh the costs of new equipment, etc., then the firm should go ahead and comply.

While the costs of compliance are fairly well known and can pretty much be taken for granted, the actual cost of non-compliance is not so clear. There may be a fine associated with exceeding pollution limits, but that number must be adjusted to account for the possibility of violations going unnoticed. Even a large fine will not be much of a deterrent if the chance of getting caught is low. The same goes for lawsuits against the company. An expected payment to harmed individuals can be multiplied by the probability of any individual actually suing and having a court find in their favor. So the basic calculation that the firm performs ends up looking something like this:

If F(pc) + L(ps)(pj) < C then do not comply.
If F(pc) + L(ps)(pj) > C then comply.

where F is the fine for noncompliance, pc the probability of getting caught, L the expected lawsuit costs, ps the probability of someone suing, pj the probability of an unfavorable ruling, and C is the cost of complying with the regulation).*, **

Or, put another way, if C-[F(pc)+L(ps)(pj)] > 0, then crime does pay and the firm will purposefully violate the regulation. That is, of course, so long as they are acting to maximize revenue and reduce production costs.

The firm, by itself, will probably not be able to much affect C, but it could take definite action to alter the values pc and pj. For instance, a firm might lobby in favor of bills to reduce the number of regulators or to reduce the funding of regulatory agencies. A firm would also want to lobby for self-reporting laws that limit or erase a company's liability if they turn themselves in. This is almost a best case scenario for the firm. It is then free to violate the regulations and, when it seems likely that charges are about to be filed, report the violations themselves and avoid some or all of the fine(!). Altering pj would include things like trying to make sure friendly judges get elected in areas where cases are likely to be heard, and to have cases moved if the local courts are unfriendly.

Anything that can be done by the firm to minimize pc and pj is likely to be money well-spent, since even a small change in either one could drastically alter the cost-benefit analysis. The ethical CEO, of course, is obliged to maximize share-holder value and it would therefore be unethical for the CEO to not pursue whatever tactics, so long as they don't cut into profits, that s/he thinks likely will reduce the left-hand side of our first two equations. Not to do so would be to increase the firm's overall costs which would ultimately cut into the profit-margin and dividends of share-holders. And besides, if your firm is not doing it, some other firm probably is and will be able to capture market-share from you by exploiting their better ability to economically avoid regulation. This is the market's way of punishing unethical behavior.

This is not to suggest, however, that firms might actually do anything illegal, or that some CEOs might be so callous as to purposefully violate the law if it seems profitable to do so. It is not my intent to suggest that some savvy businessperson might encourage legislation that would make it easier for persons like him/herself to disregard the law of the land. Far be it from me!

But it is the case that this is what cost-benefit analysis and contemporary business ethics recommend, and it may well explain why so many large American corporations commonly ignore laws and regulations. Sometimes it pays to break the law, even if you do get caught. And if it pays (your stockholders), says business ethics, then you have every right, even a responsibility, to do it.

*The calculation is, of course, somewhat more complex than I'm presenting here; namely there being more variables on the left-hand sides of the inequalities, but the underlying logic is the same, regardless.

** Another aspect that could be added to the C sides of the inequalities would be the forgone benefits that would have resulted from non-compliance.  For instance, a non-complying firm might be able to sell its goods cheaper than competitors who are complying with the regulation, since noncomplying firm's costs will be less.  This will likely steal away some of the competition's customer base which could prove a long-term benefit, even if the firm eventually has to comply and raise prices.  

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