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In Defense of Social Responsibility of Business

V. Sivarama Krishnan Assistant Professor (Finance)

University of Central Oklahoma [email protected]

ABSTRACT

Milton Friedman wrote in 1971 that the social responsibility of business is to increase its profits. Ever since, economists and finance academics have convincingly argued, generally to other economists, finance academics and captive students, that maximizing shareholder wealth is good not only for the shareholders but also for the society. The firm creates wealth when it maximizes shareholder value and the society benefits from the increased wealth. Others have argued that corporations have a social responsibility and should look beyond simply maximizing shareholder wealth. Corporate social responsibility has now been accepted by managers and corporations regularly proclaim their achievements in this regard. While what constitutes social responsibility depends on who defines it, more and more managers are willing to consider it as part of their management responsibility. Some of the formal views on social responsibility have come together under the rubric of what is loosely known as stakeholder theory. This paper provides an economic rationale as to why social responsibility may be good not only for the society but also for the corporation and its shareholders. Economic justification for social responsibility may lie in situations where the market imperfections make the corporation the best provider of certain services.

I. INTRODUCTION

Milton Friedman, in his much acclaimed and oft-quoted piece (Friedman (1971)) suggested

that the only social responsibility a corporation has is to increase profits and make the owners/shareholders wealthy. This has been the accepted wisdom for many economists as well finance academics, who have argued that shareholder wealth maximization should be seen as the normative and ideal goal on which all business decisions should be based. Shareholder wealth maximization is seen as the desirable goal not only from the shareholders' perspective, but also as for the society. Support for this view comes from, among others, Sternberg (1999) and Jensen (2001). According to this view, firm wealth maximization leads to the maximization of society’s wealth as well.

A very different view comes from the proponents of corporate social responsibility (CSR). CSR has now become an accepted part of managers’ vocabulary (See for example, Fombrun (2005) and Davis (2005)) around the world and companies as diverse as Hewlett Packard and Tata Motors of India proudly proclaim their CSR initiatives. There is growing support for CSR among at least a section of business school academics that see CSR as part of stakeholder interests and management responsibility. Much of the views heard under the broad rubric of what is loosely termed stakeholder theory can be applied to the debate on CSR.

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While there is no general agreement as to what constitutes good CSR, it is seen generally as going beyond the classic economic paradigm, a-la Friedman, of profit/shareholder-wealth maximization. While the proponents of CSR, as well as the broader stakeholder theory, differ widely in terms of the details, there is a general consensus among them in the rejection of the primacy of owners or shareholders. This flies directly in the face of the classic profit maximization and shareholder wealth maximization (SWM) paradigm and challenges the perceived wisdom of in financial economics.

This paper attempts to identify the source of the differences between the proponents of CSR and the supporters of SWM and then present an economic rationale for supporting CSR in some situations. The paper is organized as follows. The first section presents an overview of the prevailing view of the supporters of CSR and stakeholder theory. This is followed by a summary of the SWM paradigm. The next section presents our attempts at finding a meeting ground between the two views. We then extend the arguments of Amalric and Hauser (2005) and suggest that it is possible to find situations where CSR not only makes economic sense but can seen as adding value for the firm and its shareholders. The last section offers concluding comments.

II. CSR and THE STAKEHOLDER THEORY

The intellectual underpinning for the corporate social responsibility view rests on the stakeholder theory, which in turn has its academic roots in research related to business ethics and business and society. CSR view has now branched off on its own and has a number of proponents and a host of consultants, practitioners and non-governmental organizations (NGO) espousing its benefits as well as making it a corporate imperative (Fombrun (2005) and Davis (2005). The role of NGOs in the popularization of CSR and making it more acceptable in the corporate world cannot be overstated. Fombrun (2005) reviews the evolution of CSR in different countries and reports that various standard setting initiatives have developed, particularly in Europe where regulatory actions on the part of pan-European authorities have played a key role. Much of the initiatives in the US have come voluntarily from corporations. Davis (2005) suggests that corporations have responded partly under pressure from NGOs and could actually benefit from pro-active strategies which anticipate the issues that shape the social context of business. He suggests that, while shareholder value is the critical measure of success, companies will benefit if CEOs were to articulate the purpose of business as “the efficient provision of goods and services that society wants.”

Freeman (1984) is regarded as the original proponent of the stakeholder concept, which can also be seen as providing the conceptual framework for the social responsibility view. Freeman argued that corporate management should look beyond shareholders and proposed a stakeholder perspective in managing the firm. Since then, a number of books and articles have been written on what is purported to be the stakeholder theory. There is little consensus on all the essential features of the theory including who the stakeholder is. Jones and Wicks (1999) have a provided a good review of the current research and also attempt a synthesis of the extant research into a “convergent” theory. Phillips, Freeman, and Wicks (PFW) (2003) give a critical account of what the stakeholder theory is and is not.

Jones and Wicks (1999) attempt to develop a convergent stakeholder theory using the taxonomy suggested by Donaldson and Preston (1995) as the starting point. The three classes proposed by Donaldson and Preston are: instrumental, descriptive and normative. The instrumental version of the theory implies that certain actions by managers would result in certain outcomes. In

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the CSR context, this would simply imply that managers should attend to CSR and stakeholders as a means to achieving shareholder value. The descriptive version is about the actual managers’ behavior. The normative version suggests that managers should behave in certain ways. Jones and Wicks further classify the normative version as ethics based and the instrumental and descriptive as social science based theories.

Current empirical studies of actual managerial behavior, at least in the US, do not lend much support to the descriptive version (Jones and Wicks (1999), Margolis and Walsh (2003)). Jones and Wicks find the instrumental stakeholder theory more promising; managers accept CSR in the belief that it is good for profits. Post, while skeptical, calls these the “business case for CSR” and lists reputation, worker productivity, and market opportunity as the possible benefits of CSR. PFW (2003) note that a general version of this would be found acceptable even by (Jensen (2001) and Sternberg (1999), who hold shareholder wealth maximization to be the primary goal.

The normative version emphasizes the “moral and ethical” arguments for the stakeholder perspective of looking at the firm and its objectives. This view would clearly reject the shareholder wealth maximization as the primary goal for the firm. This implies some sort of absolute responsibility to society above and beyond what is called for legal business behavior.

The following could be seen as the key elements of the stakeholder theory and therefore social responsibility view (see Jones and Wicks (1999), PFW (2003) and Freeman and Phillips (1999)):

 Intrinsic worth in the claims of all legitimate stakeholders and not just shareholders.  No single objective function like SWM can do justice to the complexity of the firm.  Rejection of the primacy of shareholders.  Compatibility of morality and capitalism.  Firm as a nexus of relationships, not contracts.  Rewards should be related to contribution.

It appears that an overriding concern for most of the stakeholder theorists is that the management of the firm may exclude the stakeholders other than shareholders from legitimate rewards as well as participation in key decisions concerning the future of the firm and their own future. PFW (2003) argue “an organization that is managed for stakeholders will distribute the fruits of organizational success (and failure) among all legitimate stakeholders.” Questions seldom asked in the stakeholder and CSR literature include:

- Why this – failure to distribute organizational fruits of success among organizational stakeholders in proportion to their contribution – would happen in a competitive market place?

- Would the stakeholders be willing to take on the fruits of failure? - Would the stakeholders (or which stakeholders) be willing to share the risk of the

business and give up their explicit claims? III. PROFITS/SWM PARADIGM

The SWM paradigm puts shareholder wealth maximization as the primary goal of corporate management and is built upon the classic competitive markets assumption. It is assumed that all participants who have transactions with a firm - employees, suppliers, customers, lenders, etc. - are seen as willing participants in free and competitive markets and are fully compensated at fair market prices for their services/supplies or get fairly valued products/services for the prices they pay. The

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shareholders are unique because they are residual claimants and they do not have prior, explicit or implicit claims. They can add to their wealth only after satisfying all the prior claims of every other participant. They bear all the risk of failure and therefore it is only fair that they get the rewards. The model also assumes that there are no externalities or any harm or damage done to any non-participant in the transactions. Given these assumptions, shareholder wealth maximization is good for not only the shareholders and but also the society because the shareholders’ wealth comes from wealth created by the firm after fully compensating everyone involved and the society for all the resources used.

The shareholder wealth maximization paradigm is seen as moral and ethical (Friedman (1971), Jensen (2001), Sternberg (1999), Coelho, McClure and Spry (2003)) by its proponents. Any legal market transaction where all participants are free and willing participants is considered moral. This is seen as the foundation of the free market system. Jensen (2001), Sternberg (1999) and Coelho, McClure and Spry (2003) all argue that Stakeholder theory is incompatible with substantive objectives, which are needed to run businesses effectively.

IV. AN ECONOMIC RATIONALE FOR CSR

The essential difference between the stakeholder theory/CSR view and the SWM paradigm lies in the assumptions, explicit and implicit, which are built into the respective analytical frameworks or models. The SWM paradigm assumes that the different stakeholders are not only free and voluntary players but are also able to get their fair reward or compensation because they interact with the firm through free and competitive markets. There is no externality, no one is a weak or incompetent player and the governments are fully capable of addressing externalities and protecting weak or incompetent players. Any market imperfection or failure is the exception rather than the rule. The stakeholder theorists, on the other hand, seem to go the other way and assume that firms cannot take free and competitive markets for granted and firms have to take specific actions to ensure fair rewards and compensation for all the stakeholders and also provide benefits to society beyond their goods and services. A dialogue between the two camps is possible only after we acknowledge these fundamental differences between them.

Signs of compromise may be emerging as evidenced by changing attitudes of at least some of the supporters of SWM. Jensen (2001) while rejecting most of the claims of the stakeholder theory concedes that a firm cannot maximize value if it ignores interests of its stakeholders. He proposes what he calls “enlightened value maximization” or its identical twin, the enlightened stakeholder theory. Long-term value maximization is specified as firm’s objective. This objective can, of course, be satisfied only with the cooperation and support of all relevant stakeholders. Management’s role is critical in motivating all the stakeholders and ensuring this cooperation. Enlightened value maximization, in short, says that a firm cannot maximize value if it ignores or mistreats any important stakeholder group. By the same token, the enlightened stakeholder theory implies that firm value is the goal, but the processes and the audits suggested by the stakeholder theorists should form the basis of action towards motivating all the key stakeholders. Jensen’s enlightened value maximization or stakeholder theory resembles very closely the instrumental version of the stakeholder theory and perhaps would satisfy many of the main stream supporters of CSR.

It should be noted that while the SWM paradigm assumes competitive markets and no market imperfections, finance theory has evolved over time to include effects of some market imperfections. These, however, relate to imperfections in the financial markets or the transactions among

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shareholders, lenders, and managers. Two areas of extensive research and model development include agency relationships and information asymmetry. It is interesting to note that PFW (2003) quote a legal opinion to argue that managers should be considered as agents of not just shareholders but for the entire firm and therefore all stakeholders. PFW argue that the “… corporation is not coextensive with the shareholders.”

While Jensen and Sternberg will convince most economists, it does not appear to convince ardent stakeholder theorists. PFW (2003) while pleased that both Jensen and Sternberg accept the instrumental version of the theory, also feel that most of the characterization by the critics of the stakeholder theory are either unjust or are the result of misinterpretation of what the theory stands for. PFW attempt to answer the criticisms made by Jensen and Sternberg. However, careful reading of all the papers involved would give the distinct impression that the two groups are talking over the heads of each other. Clearly, given the assumptions of free exchange by voluntary players in a competitive market environment, most if not all of the arguments made by Jensen and Sternberg would be vindicated. Stakeholder theory supporters appear to have something else in mind. While competitive markets are taken for granted in the finance paradigm, stakeholder theorists seem to shy away from the concept. In other words, stakeholder theory implicitly assumes market imperfections and firms have power over the different stakeholders. The stakeholder theorists also seem to believe that in the real world, no stakeholder except perhaps stockholders would get a fair shake if he/she is left to market transactions.

The key question is to what extent the assumption of fair and competitive markets is valid for the different stakeholders. One wishes the stakeholder theorists would explicitly spell this out. In any case, the fear seems to be real and the important question that is not raised by either side is how valid are the assumptions of free and competitive markets. For examples do some firms have power over employees or suppliers as is commonly believed by many in the media in the case of companies like Wal-Mart? Do some firms have monopoly powers over customers? Of course, in order to justify the stakeholder view, one should not only see market failures or imperfections, but also lack of governmental regulations or legal restrictions on the firm.

Amalric and Hauser (2005) attempt to provide economic justification for CSR by pointing out that under various conditions of market imperfections, firms can use CSR to increase demand, boost reputation, and reduce regulatory risk. Similar views are also seen in Davis (2005). While these arguments are not new (see Post (2006)), Amalric and Hauser seem to clearly imply that CSR makes sense only under market imperfections. They also, perhaps, imply that in the real world, market imperfections are all too common.

Our view is that one does not have to be a hard-core CSR fanatic to agree that there are instances of market imperfections when the assumptions built into the SWM paradigm do not hold. This justifies a clear role for CSR. Examples of these imperfections are rather easy to find in lesser developed countries in Africa or Latin America or Asia where market failures are occasionally compounded and made worse by government failures are incompetence. Such situations, be it in Africa or Latin America or the occasional Katrina in the US or the immigrant conditions in France, provide opportunities for CSR, in the best sense of the term, for corporations. These are also the situations where the CSR activities should enhance value for the firm’s shareholders. An extension to the general case is when a company finds itself with a competitive advantage in providing a good or service beyond its normal products and services. A multinational oil company in Nigeria may be in the best position to provide not only schools for the local village children, but also drinking water

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and other basic amenities. One may be walking a fine line here, but the long-term economic value could easily be identified perhaps in contrast to the short-term discounted cash flow net-present- value, both in societal terms and from the narrower corporate perspective. It is not surprising that some corporations actually take this approach. An example closer to home is the extension of services by Wal-Mart and Home Depot during the near break down of government services.

V. SUMMARY This is paper attempts to the bridge the gap between two competing views on the role of corporations and their social responsibility. We compared and contrasted CSR/stakeholder theory views with the traditional wealth maximization paradigm, which puts shareholder wealth maximization as the primary corporate goal. It appears that the proponents on either side of this highly contentious debate, to the extent there is a debate, fail to understand the other side’s perspective. This is mainly because each side starts from very different assumptions about the state of the markets and competition. We suggest that it is possible to find situations where markets are less than perfect and corporations may be best positioned to provide goods and services beyond their normal products and services. This could be seen as CSR with economic value to the society and the firm.

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Activities. Journal of Corporate Citizenship, Winter 20: 27-38. Coelho, Philip R.P., James E. McClure, and John A. Spry. 2003. The Corporate Responsibility of

Corporate Management: A Classical Critique. Mid-American Journal of Business 18(1): 15- 24.

Davis, Ian. 2005. What is the Business of Business? McKinsey Quarterly 3: 104-113. Donaldson, Thomas and L. Preston.1995. The Stakeholder Theory of the Corporation: Concepts,

Evidence, and Implications. Academy of Management Review 24(2): 237-241. Donaldson, Thomas. 1999. Making Stakeholder Theory Whole. Academy of Management Review

24(2): 237-241. Freeman, Edward R. and Robert A. Phillips. 1999. Stakeholder Theory: A Libertarian Defense.

Paper presented at the Society for Business Ethics Annual Meeting at Chicago. Available for download from the Social Science Research Network Electronic Paper Collection at: http://papers.ssrn.com/abstract=263514.

Freeman, R. Edward. 1984. Strategic Management: A Stakeholder Approach (Boston: Pitman Publishing Inc.)

Freeman, R. Edward. 1999. Divergent Stakeholder Theory. Academy of Management Review 24(2): 222-227.

Friedman, Milton. 1971. The Social Responsibility of Business is to Increase its profits. The New York Times Magazine. September 13.

Fombrun, Charles. J. 2005. Building Corporate Reputation through CSR Initiatives: Evolving Standards. Corporate Reputation Review 8(1): 7-11.

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Jensen, Michael C. 2001. Value Maximization, Stakeholder theory, and the Corporate Objective Function, Amos Tuck School of Business, Dartmouth College Working paper No. 01-09. Available for download from the Social Science Research Network Electronic Paper Collection at: http://papers.ssrn.com/abstract=220671.

Jones, Thomas. M and Andrew C. Wicks.1999. Convergent Stakeholder Theory. Academy of Management Review 24(2): 206-221.

Margolis, Joshua D. and Walsh, James P. 2003. Misery Loves Companies: Rethinking Social Initiatives by Business. Administrative Science Quarterly 48: 268-305.

Phillips, Robert, A. 2003. Stakeholder Theory and Organizational Ethics. Berrett-Kohler, San Francisco.

Phillips, Robert, R. Edward Freeman, and Andrew C. Wicks. 2003. What Stakeholder Theory is Not. Business Ethics Quarterly 13(4): 479-502.

Post, Issac. 2006. Is CSR OK? National Review Online. March 3. Sternberg, Elaine. 1999. The Stakeholder Concept: A Mistaken Doctrine. Foundation for Business

Responsibilities (UK) working paper. Available for download from the Social Science Research Network Electronic Paper Collection at: http://papers.ssrn.com/.

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