Introduction to the Special Issue on Nonmarket Strategy and Social Responsibility

This special issue on nonmarket strategy is the outgrowth of a series of conferences on strategy and the business environment hosted by the business schools at Harvard, Northwestern, Pennsylvania, and Stanford universities. A general solicitation of submissions was made, and the majority of the papers in this issue were not presented at the conferences, but were part of the general journal submission process. In accordance with the journal's general policy, the final selection of the papers was made by the journal's editorial board, and we were asked to provide an introduction to this issue. All economies are defined by formal and informal norms and regulations that structure market competition. These “rules of the game” vary significantly across countries. Many barriers to imitation and entry, for example, originate from specific legal rules or government policies that favor some capabilities over others. These rules, and in many cases their enforcement, are not fixed, well-defined constraints, but are determined, implemented, and interpreted by legislatures, government administrative agencies, judicial institutions, public sentiment, and ethical consensus. The resolution of ambiguity and direction of change is neither exogenous nor divorced from strategic considerations. Rather, the process involves interest groups interacting within a system of institutions that includes but is not limited to the various branches of government, the media, and nongovernmental organizations. Both competitive advantage and industry profitability are affected by this interaction. Effective business strategies thus should include actions to influence the outcome of such processes. The analysis and development of successful strategies to shape the rules of the game to an organization's advantage constitute the domain of nonmarket strategy. Nonmarket strategy has traditionally focused on public institutions such as legislatures, regulatory agencies, or the courts. However, in recent years, researchers have begun to investigate various forms of private nonmarket competition where private interests such as activists or NGOs try to affect company and industry practices using the arena of public sentiment and the media. This presents new strategic challenges for companies in the areas of reputation management, self-regulation, and the integration of private and public nonmarket strategies among others. One such approach, the strategic use of corporate social responsibility, has received substantial interest from academic researchers, and this volume also contains a set of papers that investigates corporate social responsibility in the context of nonmarket strategy. The papers included here consider a broad array of nonmarket strategies, including those that are commonly associated with corporate social responsibility. The firms considered operate in both the market and nonmarket environments, and the models incorporate both private and public politics. The first set of papers focuses on public actors. De Figueiredo and Edwards study the effect of campaign contributions on regulatory outcomes in the telecommunications industry. Dal Bo, Dal Bo, and Di Tella provide a formal model of the strategic interaction between long-run institutional actors and short-run players such as interest-groups. This is followed by two contributions on private nonmarket actors. Baron and Diermeier provide a model of strategic activism, while Anand, Di Tella, and Galetovic provide a model of media bias. Four of the papers address aspects of corporate social responsibility (CSR). The papers include (1) a valuation theory that identifies how the cost of CSR is borne, (2) a theory of the trade-off between private self-regulation by consumers and the public regulation of an externality, (3) the use of CSR to favor stakeholders who can entrench a low quality manager against replacement, and (4) an empirical study of whether firms engage in strategic CSR to increase their profits. De Figueiredo and Edwards provide an empirical analysis of the potential impact of one particular instrument of nonmarket strategy: campaign contributions. In contrast to most studies of campaign contributions the paper is able to measure regulatory outcomes directly. The idea is to study the (substantial) variation of the access price for local loops of incumbent telephone networks and to explain this variation by looking at campaign contributions by incumbent telecommunications companies and entrants at the state level. The authors establish a significant correlation between contributions and price levels even when controlling for various political, economic, and institutional variables. On average they show than a 10% increase in contributions by entrants leads to an 4% reduction in the transfer price from its mean. Dal Bo, Dal Bo, and Di Tella develop a game-theoretic model to investigate how long-run players might develop a reputation over time to influence the behavior of a sequence of myopic players when the long-run player can at some cost impose sanctions or elicit side-payments from the short-run player. As in many game-theoretic models of reputation, players can be of two types, either “rational” players who optimize or “irrational” players who reject a payment even if it was optimal. The authors prove the existence of an equilibrium where the long-run player can develop a reputation for toughness and benefits from being able to provide or demand transfers. The model provides general insights into how reputations for “toughness” are sustained, and Dal Bo, Dal Bo, and Di Tella discuss two implications: the first involves an interest group or activist group that would like to influence the behavior of a public officials or a firm. The second application is to the case of a corrupt judge who can impose a sanction on a defendant and then request bribes to set the penalty aside. The later case is motivated by Chicago Judge Maloney who was convicted of taking bribes and extorting defendants. Subsequently, appeals courts needed to decide whether the imposed sentences and sanctions should be upheld. The model identifies incentives for corrupt judges to impose tougher sanctions, which suggests that a reduction in sentences is warranted on appeal. Political activists and NGOs play an increasingly important role in the nonmarket environment of firms. Increasingly their goal is to target consumers and other components of a company's value chain to force changes in the target company's business practices, often with the goal of inducing industry-wide self-regulation. Baron and Diermeier provide a formal model of strategic activism, targeting strategies, and the nonmarket competition between activists and firms. The core model formally captures a “campaign” consisting of a current practice, a demand by the activist, a threat, and a reward conditional on meeting the activists' demand. The authors solve the model and discuss various implications of the model for targeting strategies and the nature of campaigns. For example, activists emphasize harm over rewards, and campaigns may be more aggressive and negative the more responsive is the target. Baron and Diermeier then show how companies can use proactive strategies such as self-regulation or corporate social responsibility initiatives to preempt strategic targeting. With multiple potential targets this can create a “race to the top” leading to increasingly constraining industry self-regulation. Alternatively, companies can develop a reputation for toughness or contest a campaign. They also discuss the importance of commitment for both activists and firms. Obtaining favorable media coverage is an important component of activist strategies. Frequently the media is accused of bias in its reporting about companies. Recent empirical work has provided some systematic evidence for this claim. The paper by Anand, Di Tella, and Galetovic provides a theoretical account of media bias as product differentiation. Coverage of an event is modeled as sequential entry by media outlets into a market for information where customers, that is, viewers and readers, hold heterogeneous prior views about the event. The market for news then resembles a differentiated product market where media “bias” simply occurs as product differentiation that serves different customer segments, here characterized by different ideologies. The authors then derive comparative statics results showing how media bias varies depending on how much customers value truthful reporting and how diverse their prior ideologies are. The paper also shows that issues that do not fall neatly into existing ideological dimensions will be less biased. The last group of papers addresses various aspects of corporate social responsibility (CSR). Baron considers the formation of firms that allocate a share of their profits to social causes. The motivation for engaging in CSR comes from citizens who have warm glow preferences for the social expenditures of the firm. Citizens can allocate their wealth among savings, personal giving to social causes, and in the capital market the purchase of shares of the firm. Citizens may receive a warm glow from holding shares of a firm that makes social expenditures, but shareholding can be an imperfect substitute for the warm glow from personal giving. The capital market imputes a price to the firm's social expenditures, where the price is the marginal rate of substitution between the warm glow from shareholding and personal giving for the citizen who is indifferent between the two. The market value of the firm exceeds the value of its financial performance but is less that the market value without the social expenditures. CSR is thus costly. When the social expenditures of the firm are fully anticipated, the social entrepreneur who establishes the firm, and not shareholders, bear that cost. If the corporate social responsibility is a surprise, shareholders bear the cost. Milton Friedman's objection to CSR may be interpreted as pertaining to unanticipated surprises. The social entrepreneur is willing to bear the cost because either doing so expands the opportunity sets of citizens in consumption-social giving space or there is an entrepreneurial warm glow from the firm's social expenditures. A social entrepreneur carries strategic corporate social responsibility beyond profit maximization and market value maximization. A firm that makes social expenditures may be subject to take over in the capital market, so for CSR to be sustainable shareholders must not sell their shares in response to an opportunity for a capital gain. This provides a role for social-responsibility mutual funds. Calveras, Ganuza, and Llobet present a model incorporating both private and public politics. Citizens are heterogeneous and have dual roles as consumers and voters. As consumers they have heterogeneous warm glow or altruistic preferences to mitigate a negative externality associated with the production that fulfills their demand. Citizens as consumers can voluntarily reduce their consumption to reduce the externality and as voters can enact regulation to force firms to use a cleaner technology. Products are differentiated by how clean their technology is, firms maximize profits, and the industry is perfectly competitive for each technology demanded by consumers. Citizens can choose under majority rule to regulate the externality by setting a minimum technology standard, and the preferences of the median voter determine the outcome of the collective choice. The median voter may prefer not to regulate optimally if enough consumers privately mitigate the externality. Referring to consumers' mitigation as private politics, the authors argue that private politics can crowd our public politics (regulation) when consumers with weak preferences for private mitigation free ride on consumers with strong preferences. If there are many citizens who self-regulate, the median voter is one of them and prefers optimal regulation. If there are no consumers who self-regulate, a majority of citizens also prefers optimal regulation. In the intermediate case citizens who do not self-regulate free-ride on the mitigation by those who do. That is, an increase in the proportion of citizens who self-regulate has two effects. First, it results in a median voter who prefers more stringent regulation, and second, it increases the incentives of citizens to free-ride. The authors conclude that private regulation may not be a good substitute for public regulation. Cespa and Cestone consider another aspect of corporate social responsibility—the use of CSR for the private gain of managers. A manager is self-interested and obtains a private gain from remaining in office. When that gain is sufficiently large relative to her financial return, the manager can have an ex ante incentive to commit to a policy that favors stakeholders over shareholders. The private gain could simply be a preference for the acclaim from those stakeholders who benefit from the firm's social expenditures, but the focus of the authors is the richer issue of management entrenchment. The model is thus set at the intersection of corporate governance and corporate social responsibility. An incumbent manager can use CSR to favor the firm's stakeholders over its shareholders. A low quality manager has an incentive to do so if that will elicit stakeholder opposition to a control transaction that would replace the incumbent with a higher quality manager who would better serve shareholder interests. Stakeholders can thwart management replacement by mounting a campaign in support of incumbent management, and the campaign is more likely to be successful the stronger are the stakeholder activists. The interests of the entrenched manager and the stakeholders thus can be aligned. These interests are affected by the quality of corporate governance. The incentive to serve the interests of stakeholders is stronger the better is corporate governance, since then it is more likely that the manager will be replaced. When corporate governance is weak so that managers can entrench themselves through charter provisions, managers have weaker incentives to cater to stakeholders. The incentive of the manager to favor stakeholders can be mitigated by explicit stakeholder protections provided by government or by external private monitoring groups, such as NGOs or ethics-based mutual funds. The manager who has an incentive to favor stakeholders is opposed to such explicit stakeholder protection, whereas shareholders can prefer it, even when it is costly to the firm, when managers have a strong incentive for entrenchment or stakeholder activism is strong. Shareholders thus face a tradeoff between costly stakeholder protection and a reduction in managerial entrenchment that leads to higher quality management. Siegel and Vitaliano provide an empirical test of the motivation for corporate social responsibility. They hypothesize that firms engage in CSR to improve their profits. That is, CSR is strategic and provides product differentiation or signals high quality to consumers. Some firms may have stronger incentives to use strategic CSR than others, and this should depend on the nature of the goods they sell. For example, CSR can signal unobservable attributes of a credence good, such as the conditions under which the good was produced. Similarly, for an experience good whose quality can only be assessed through use, CSR could signal high quality if a “socially better” firm can be expected to produce a higher quality product. The authors thus identify firms according to whether their products are search goods and nondurable (repeat purchase) experience goods, which may be thought of as goods for which information is readily available so signaling provides little value. In contrast, experience goods and credence goods could benefit from CSR signaling that indicates to consumers that products are high quality. The hypothesis tested then is that firms producing experience and credence goods are more likely to engage in CSR than are firms that produce search and nondurable experience goods. Testing this hypothesis requires assessing the type of product a firm produces and measuring CSR, both of which are inherently difficult. The authors exclude conglomerate firms that produce many products as well as industrial products firms that do not interact with the public. The CSR data are from Kinder, Lyndenberg, and Domini (KLD), which assesses twelve dimensions of CSR. Three measures are used in the empirical analysis. One is inclusion in the KLD Large Cap Social Index, but this Index is based in part on blanket exclusions, such as defense contractors and nuclear power producers. Siegel and Vitaliano thus also consider measures of CSR that leave out the blanket exclusions. These measures of CSR serve as the dependent variables in a probit model predicting which firms will engage in CSR as a function of the products they produce and their size, market capitalization, and R&D expenditures. The empirical estimation confirms the main hypothesis, which supports the concept of strategic CSR. They also find that large firms are not more likely to engage in CSR, and the evidence is mixed about whether more profitable firms are more likely to provide CSR.