The Market for Honesty
The Free Market Penalizes Dishonest Business People
FEBRUARY 01, 1999 by DWIGHT R. LEE
The recurring theme of all my columns has been that economics is a study of how people cooperate with each other and that market economies succeed because of the incredible amount of cooperation they promote. Market cooperation, like all cooperation, depends on a high level of honesty. People who cannot trust each other cannot cooperate with each other, certainly not for long. And with the market, it’s not just a matter of trusting a few people whom we know and care about. Market cooperation depends on our being able to trust large numbers of people, most of whom we will never know.
Consider the behavior of business people. If the proverbial man from Mars observed our business activity, he would surely conclude that business people are extraordinarily honest. For example, they sell precious gems that really are precious to customers who cannot tell the difference between diamonds and cut glass. They promise not to raise the price of a product once customers commit themselves and make switching to another product costly—and they keep the promise. They make good-faith promises that the business they own, but are about to sell, will continue to give their customers good service. The examples could be continued indefinitely since honesty and trust are essential for all but the simplest business transactions.
I am not naïve enough to argue that business people are never dishonest. Just like people in all walks of life, some will cheat, lie, and steal to snatch short-run advantage. But they are not nearly the scoundrels as presented in the media and popular entertainment. According to one study, almost 90 percent of all business characters on television are portrayed as corrupt.1 In fact, business people can be depended on to act more honestly than most. This is not because business people are inherently more virtuous than others (though there is no reason to believe they are less virtuous), but because the free market penalizes those who do not provide consumers with things they value—and consumers value honesty.
The reason the market penalizes dishonesty is obvious at one level. Those who fail to provide the quality they promise, and charge for, may profit in the short run, but not in the long run. But even in the short run there are gains from honest dealing, and those who can credibly promise to deal honestly can capture some of those gains. So business people are strongly motivated to put themselves in situations in which dishonest behavior is quickly penalized. By doing so they are better able to entice customers with assurance of everyday honest dealing.
Committing to Continuity
Consider the fear of dishonesty that can arise when it is believed that a business is about to shut down, say, because the proprietor is getting old. Even if such a proprietor has no intention of cheating customers, they will have reason to worry without some credible assurance of the proprietor’s long-run interest in the business. An owner can often provide this assurance by bringing his offspring into the business (“Samson and Sons” or “Delilah and Daughters”). Not surprisingly, research shows that children of single proprietors are three times more likely to follow in their parents’ lines of work than the children of others. Even large corporations, with lives that extend far beyond those of any of their managers, often depend on single proprietorships to represent and sell their products. This explains why Caterpillar, for example, has a school on running Caterpillar dealerships for the sons and daughters of the owners of those dealerships.
To consider another example of the importance of business continuity in promoting honesty, ask yourself where you would rather shop for an expensive piece of jewelry, a jewelry store with a well-advertised brand name and ornate fixtures, or a sidewalk vendor operating out of a Volkswagen van parked at the curb? What could the store do with its brand name and fixtures if it went out of business? Not much, and this tells customers that the store has a lot to lose by misrepresenting its merchandise to capture short-run profits. It has made a commitment to staying in business by being honest.
Intel, having received a patent on its 286 microprocessor in the early 1980s, immediately gave up its monopoly by licensing a competitive firm to also sell the microprocessor. Why would any company give up a legal monopoly? Because of the importance of honesty. Intel was willing to sell its new microprocessor to computer manufacturers at a reasonable price, and promised to do so. But the manufacturers were afraid that once they committed to using the new microprocessor (making expensive changes in their production process that would be difficult to reverse), Intel could exploit its long-term patent monopoly by raising the price. Intel could make a credible promise that it would maintain competitive prices by giving up its monopoly. Committing itself to honest dealing was more important to Intel, and more profitable in the long run, than exploiting a monopoly position in the short run.2
Selling and Repairing
It is difficult for consumers to determine the quality of automobile repair. They can generally tell if the work eliminated the problem: the car starts, the rattle is gone, the oil light is off, and so on. But few people know if the repair shop charged them for only the repairs necessary, or if it charged them for lots of parts and hours of labor when all the mechanic did was tighten a screw. One way repair shops can reduce the payoff from dishonest repair charges is through joint ownership with the dealership selling the cars being repaired. In this way the dealer makes future car sales largely dependent on honest repair work. Dealerships depend on repeat sales from satisfied customers, and an important factor in how satisfied people are with their car is the cost of upkeep and repairs. The gains a dealership could realize from overcharging for repair work would be quickly offset by reductions in car sales.
Automobiles are not the only product for which it is common to find repairs and sales tied together in ways that provide incentives for honest dealing. Many products come with guarantees and warranties entitling the buyer to repairs and replacement of defective parts for a specified period. These guarantees provide confidence in the seller’s honesty when advertising the quality of his product.
Some will always go for the short-run gain through deceit and dishonesty. But the greater the freedom of others to compete with credible commitments to honesty, the less dishonesty pays even in the short run. The cooperation that characterizes the free market would never be possible without the high level of honesty and trust motivated by market competition.