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Corporate Social Responsibility and markets: The view from economics

Corporate Social Responsibility and markets: The view from economics
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CSR, or Corporate Social Responsibility, is often viewed as an obvious, readily understood, homogenous concept. Yet a close look at CSR research challenges this view. Researchers have proposed a plethora of definitions for CSR, with each definition assigning a particular meaning to CSR. Orlitzky et al. (2011) speak of the “inconsistencies and debates regarding the proper definition of corporate social responsibility (CSR)” (p. 8).

The various definitions that researchers propose for CSR can be classified based on how they view the role that firms play in society. On one extreme are scholars like Levitt (1958) and Friedman (1970) who caution against firms wading into territory other than profit maximization. They see a firm’s sole responsibility, social or otherwise, as consisting of maximizing shareholder wealth and increasing profits.

At the other extreme are scholars who contend that firms need to consider stakeholders beyond shareholders, lest these stakeholders withdraw their support or business and take it elsewhere (Freeman 2010, Guay et al. 2004). They argue that firms should look beyond maximizing profits and engage in “actions that appear to further some social good, beyond the interests of the firm and that which is required by law” (McWilliams and Siegel 2001 p 117). Corporations, here, have not only an economic responsibility (that is, increase profits) but also other responsibilities, including legal, ethical and discretionary ones (Carroll 1979).

The different definitions that researchers have proposed for CSR highlight that underlying CSR is the assumption that there is a conflict between what is good for the firm and what is good for society. More specifically, the views in Levitt (1958) and Friedman (1970) suggest that when firms consider what is good for society, they harm themselves. The views in Freeman (2010) and Guay et al (2014), in contrast, suggest that when firms consider what is good for themselves they harm society.

There is nothing automatic about this assumption that there is a conflict between what is good for the firm and what is good for society: it may or may not be true. As all beliefs, it can be examined to determine to what extent there is veracity to it. To proceed with such an examinnation, we can turn to economics, because economics has something to say about the correspondence between profit maximization (i.e., what is good for the firm?) and social welfare (i.e., what is good for society?). Scholars in economics have shown that, under certain conditions that I will discuss below, when firms maximize profits, social welfare is also maximized.

What is good for the firm can be good for society

Why does this happen? The story that economics tells us is as follows.

If firms maximize profits, they sell goods and services that individuals are willing to buy, at the indicated prices. Individuals are willing to buy as long as the value they derive from the purchased good or service is higher than the price they pay for it. The difference between the value an individual derives and the price she pays is the individual consumer surplus. Social welfare represents captures how happy consumers and firms are with their consumer surplus and profits, respectively. It is calculated in economics by summing the utility (which corresponds to, roughly, the happiness) of each member of society, that is, in our case, of consumers and firms, buyers and sellers.

Private markets achieve an efficient resource allocation in the sense that the resources of the buyer and seller are allocated so that each is as well off as possible. The seller is not able to make a higher profit (if the price were higher than that at which the good or service was sold, the buyer would refuse to do the purchase) and the buyer is not able to make a larger consumer surplus (if the price were lower than that at which the good or service was sold, the seller would refuse to sell to the individual). Social welfare is maximized in private markets.

Accordingly, there need not be a divergence between what is good for the firm and what is good for society. In markets where firms that maximize their profits, social welfare is maximized as well. Firms need not make any particular effort to be socially responsible; by maximizing profits, they are being socially responsible. From the perspective of economics, firms then do not deserve any special credit for social responsibility, since they do not make efforts beyong simple profit maximization. At the same time, economics highlights that individuals play a part in social responsibility, because of their purchasing decisions.

Enter: Market failures

Economics cautions that the correspondence between social welfare and profit maximization holds as long as there are no market failures. There are four market failures that are relevant to CSR, each of which I will now briefly touch on.

Externalities

Externalities occur when a firm’s actions affects the well-being of an uninvolved actor. Externalities can be positive or negative; I first illustrate negative externalities. Consider a firm that pollutes the water as a result of its production process. This firm affects actors who use that water, now and in the future, yet the firm does not consider the costs that its pollution imposes on them. The firm pollutes the water to a larger extent that it would if it had to take into account the cost that pollution imposes on others. The firm, in order words, over-pollutes because it does not pay all the costs related to pollution. To solve this problem, the firm needs consider all costs related to its polluting behaviour, including those that it imposes on outside individuals.

I now move on to positive externalities. Consider a firm that provides parental leave for its employees. This firm affects not just its employees but also their children and family as well as those relating to the latter (i.e., the employer of the spouse). When deciding about its parental leave, the firm only considers the benefits that it accrues from such a program, and not those that other actors accrue. The firm does not provide as much parental leave as it would if it had taken into account the benefits of the leave for all actors. The firm, in other words, under-provides leave, because it does not capture all the benefits related to its parental leave program. To solve this problem, the firm needs to be able to capture all profits from its parental leave program, including those that accrue to uninvolved actors.

When externalities exist, the link between a firm’s profit maximization and social welfare is broken. Instead, a firm that maximizes its profits may harm social welfare (as illustrated by my example of the water-polluting firm) or not sufficiently increase social welfare (as illustrated by my parental leave example).

Asymmetric information

Asymmetric information occurs when one party to a transaction has different information about the transaction than another party. For instance, an individual who purchases vegetables does not know what chemicals these vegetables have been treated with; this is information that the vegetable grower has. Yet the vegetable grower may want to not divulge information about chemicals that were involved in growing the vegetables, for fear of driving away potential customers.

If potential customers are unable to determine what vegetable growers withdold information from them, they may cease buying produce from all vegetable growers, and the market breaks down. To continue selling their wares, vegetable growers who do not use chemicals have incentives to disclose information about the lack of chemicals used in their growing process. To the extent that vegetable growers who use chemicals can lie, consumers still do not know whom to trust.

Again, the market may cease functioning.When asymmetric information exists, the link between a firm’s profit maximization and social welfare is broken. Instead a firm that maximizes its profits may harm social welfare (as illustrated by my example of the vegetable grower), or there may not even be a market where firms can maximize their profits (and individuals can generate surplus for themselves). A large literature in economics consider how to solve asymmetric information problems that causes market failures and contracting inefficiencies (Bolton & Detrawipont 2005).

Market power

A firm with market power is able to charge a price that is well the price it would be able to charge absent this power. The firm makes a larger profit as well, and consumers, because they pay a higher price, have a lower surplus. The link between profit maximization and social welfare is broken, because firms make too high a profit, and individuals have too low a consumer surplus.

Many countries have regulatory (e.g., anti-trust) agencies that monitor corporate market power (Tirole, 2016). However, such regulation may not be successful in limiting power, because power has a variety of sources and manifestations. Market power can result because firms are able to influence the political process; such influence may help them limit foreign competition, salaries they pay their employees, or protections they have to offer their workers. Moreover, such influence can provide them with government contracts, and with government assistance in obtaining foreign contracts. Market power can result because firms influence how indivuduals view the world and form their tastes. Corporations influence popular culture via control of or associations with media corporations, including social media. Research in sociology and critical theory highlights the different antecedents and manifestations of corporate power.

Behavioral biases

Indivuals may be afflicted by behavioral biases that prevent them from doing that which is good for them. For instance, they may exhibit an excessive preference for the present, and discount the future, which leads them to overconsume in the present and not consider the repercussions of this overconsumption for the future. They may pollute too much, and disconsider the effect of this pollution for the future air quality. Or they might eat too much greasy food and not take into account the effect of this consumption for their future health.

When individuals have behavioral biases the link between profit maximization and social welfare is broken. For instance, consumer welfare may decline because individuals who make purchasing decisions acquire goods and services that they may have been better off without. Researchers in behavioral economics propose a variety of solutions to behavioral biases, which revolve around nudging individuals to engage in the behavior that is best for them (Thaler and Sunstein 2008).

Finally, a note on equity, fairness, etc. The insights that economics has to offer on the link between profit maximizatin and social welfare are silent on social equity. While markets are good in reallocating resources, they take initial resource allocations as given. Individuals who lack financial resources to purchase a good they value are not able to participate in the market. Markets cannot redistribute resources to and from individuals who are excluded from participating.

To the extent that there are structural factors that prevent individuals from accessing resources, be they human or financial, and that are necessary for participating in markets, individuals cannot benefit from the market’s efficiency in resource allocation. Unsurprisingly then, markets do not necessarily generate a distribution of revenues that is equitable or that corresponds to any other idea one might have about how society should be (Tirole 2016).

References
Carroll, Archie B. 1979. “A Three-Dimensional Conceptual Model of Corporate Performance.” Academy of Management Review 4 (4): 497–505. doi:10.5465/AMR.1979.4498296.
Freeman, R. Edward. 2010. Strategic Management: A Stakeholder Approach. Cambridge, UK: Cambridge University Press.
Friedman, Milton. 1970. “The Social Responsibility of Business Is to Increase Its Profits.” The New York Times Magazine, September 13.
Guay, Terrence, Jonathan P. Doh, and Graham Sinclair. 2004. “Non-Governmental Organizations, Shareholder Activism, and Socially Responsible Investments: Ethical, Strategic, and Governance Implications.” Journal of Business Ethics 52 (1): 125–39.
Karnani, Aneel. 2011. “‘Doing Well by Doing Good’: The Grand Illusion.” California Management Review 53 (2): 69.
Levitt, Theodore. 1958. “The Dangers of Social Responsibility.” Harvard Business Review 36 (5): 41–50.
McWilliams, Abagail, and Donald Siegel. 2001. “Corporate Social Responsibility: A Theory of the Firm Perspective.” The Academy of Management Review 26 (1): 117–27. doi:10.2307/259398.
Orlitzky, Marc, Donald S. Siegel, and David A. Waldman. 2011. “Strategic Corporate Social Responsibility and Environmental Sustainability.” Business & Society 50 (1): 6–27. doi:10.1177/0007650310394323.

Photo adapted from Karyn Christner.

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