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doi: 10.1111/j.1467-999X.2010.04087.x

6995

SOCIAL RESPONSIBILITY

meca_4087

69..95

Tommy Lundgren*

Centre for Environmental and Resource Economics (CERE),

Ume School of Business

(December 2008; revised January 2010)

ABSTRACT

This paper explores the economic mechanisms behind corporate social responsibility (CSR) in a

microeconomic model of the firm. The studys motivation is to shed light on the potential causes of the

observed phenomena of voluntary over-compliance among firms. We investigate how assumptions

about costs and benefits affect CSR behavior through a stock of goodwill capital. In optimum, the firm

must balance marginal costs and benefits of investing in CSR. We characterize the equilibrium and

examine comparative statics and dynamics from a parameterized model. Finally, we link some of the

models results to the empirical literature on CSR.

1. INTRODUCTION

to technological and other constraints. Without economic incentives like

taxes or quantitative regulations, the firm might, for example, pollute too

much, or engage in some other socially detrimental behavior. A cursory look

around business environments today suggests that this view might be a bit

old-fashioned. Indeed, firms spend resources to convince potential consumers and other stakeholders that they are more socially responsible than what

the authorities or society demand. This paper seeks to explore the economic

* Financial support was provided by the MISTRA research program Sustainable investments.

Useful comments from Karl-Gustaf Lfgren, Bert Scholtens, Lammertjan Dam, Geoffrey Heal,

and participants at the workshop Corporate social responsibility and socially responsible investments, Ume University, School of Business, Ume-Sweden, 16 November 2007, 3rd Atlantic

Workshop on Energy and Environmental Economics, Universidade de Vigo A Toxa, Galicia,

45 July 2008, and the Centre of Environmental and Resource Economics Workshop, 2 October

2008, improved the paper significantly. Helpful comments and suggestions from two anonymous

referees are also gratefully acknowledged.

2010 Blackwell Publishing Ltd

70

Tommy Lundgren

mechanisms behind corporate social responsibility based on a microeconomic perspective of the firm. The ultimate objective is to shed some light on

the rationale behind the observed voluntary over-compliance among firms.

Since the publication of the report Our Common Future (1987) by the

World Commission on Environment and Development, the terms sustainability and sustainable development have become prominent in the public debate.

The sustainability debate has, in part, focused on what companies can do to

facilitate sustainable development, so-called corporate social responsibility

(CSR). One of the first attempts to bring CSR into the public debate was from

Milton Friedman who in his article in the New York Times Magazine argued

that the corporate social responsibility of firms is to maximize its profits

(Friedman, 1970). While this statement may appeal specifically to neoclassical

economists, it may also seem provocative and without nuance to others. But

as we shall see, profit maximization does not have to be in conflict with

social responsibility (see, for example, Husted and Salazar, 2006). Following

Friedmans initial definition of CSR, a number of others have followed. For

example, Heal (2008) suggests that CSR is . . . the interactions between

corporate behavior and civil and legal society, and how these interactions

structure the companys incentives on social and environmental issues.1 We

simply consider CSR to be actions that, to some degree, imply corporate

beyond-compliance behavior in the social and/or the environmental arena.

Most of the empirical studies of the effects of CSR on either a firms

economic or financial performance have been performed during the last two

or three decades (and most focus on financial performance). The plethora of

individual studies has led to at least 1015 reviews, many of them assessed in

Margolis and Walsh (2001), which reviews nearly 100 separate studies. Also,

Reinhardt (2000), Orlitzky and Benjamin (2001), Orlitzky et al. (2003), Lyon

and Maxwell (2004) and Orlitzky and Swanson (2008) summarize to a large

extent the bulk of empirical CSR literature that is currently available. Hay

et al. (2005) offer a comprehensive review from the fields of economics, law

and business. The evidence from these review studies is not conclusive, but

empirical results seem to indicate that CSR leads to positive financial performance for a firm.2

When it comes to CSR and economic performance, the research is less

extensive. Indeed, economic and financial performances are linked,3 but there

are some interesting differences worth noting. The Journal of Productivity

1

See also McWilliams and Siegel (2001), Hay et al. (2005) or Portney (2008) for similar definitions of CSR.

2

Possibly because of publication bias, i.e. negative results tend not to be published.

3

If, for example, economic efficiency is improved by CSR this will most likely show in financial

performance such as stock price through higher profits.

71

(Paul and Siegel, 2006). They note that the vast number of studies of CSR

and the effect on financial measures is, from an economic perspective, unfortunate. Instead, they suggest that a more salient issue is the relationship

between economic performance and CSR behavior, where economic performance entails technological and economic interactions between production

of output and input demands, recognizing the opportunity costs of inputs

and capital formation. Their conclusion is that the costs of CSR must be

balanced by benefits to motivate firms to carry out such activities. Another

theme issue, Paton and Siegel (2005), can be found in Structural Change and

Economic Dynamics, where CSR is studied using empirical and theoretical

tools from both finance and economics.

Compared with the empirical literature on CSR, attempts to formally

model the microeconomic mechanisms behind voluntary over-compliance at

the firm level in a consistent way are less plentiful. However, a number of

studies are worth mentioning. Bergman (1995) provides several interesting

simple static micro-models, in terms of environmentally friendly firms, that

provide a rationale for CSR behavior. A game theoretical model of voluntary

over-compliance is proposed by Arora and Gangopadhyay (1995), who

assume that firms signal their greenness. If consumers prefer to buy products from a greener firm, then the cost of being environmentally friendly

may be justified by higher revenues.

McWilliams and Siegel (2001) and Baron (2001) are probably the first two

papers that explicitly model profit-maximizing CSR in a way that accounts

for the wide range of costs and benefits to be considered when investing in

socially responsible projects.4 These papers identify the implications of CSR

when information is asymmetric between firms and consumers, discuss the

importance of reputation, and examine the strategic use of CSR (e.g. the

problem of greenwashing5). The reputation and strategic dimension of CSR

is discussed further in a subsequent dialogue between McWilliams and Siegel

(2002), Piga (2002) and Siegel and Vitaliano (2007). Furthermore, McWilliams and Siegel (2001) explicitly argue that the demand for CSR will be

4

McWilliams and Siegel (2001) outline a model in which two firms sell identical goods, but one

company decides to add an additional social attribute to its product. This attribute is valued by

some consumers or, potentially, by other stakeholders. Firm managers conduct a costbenefit

analysis to determine the level of resources to devote to CSR activities. That is, firms simultaneously assess the demand for CSR and the cost of satisfying that demand, and then determine

the optimal level of CSR to provide.

5

See, for example, Greer and Bruno (1996). Greenwash refers to companies that disingenuously spin their products and/or policies as environmentally friendly, e.g. presenting cost cuts as

reductions in resource use.

72

Tommy Lundgren

greater for experience and credence goods and services, which is empirically

confirmed by Siegel and Vitaliano (2007). Bagnoli and Watts (2003) extend

Baron (2001) and McWilliams and Siegel (2001) by analyzing how the structure of competition in the market for the private good affects CSR. Baron

(2007, 2008) provides further theoretical discussion of profit-maximizing

CSR, with a focus on managerial issues, reputation and stakeholder pressure/

incentives.

Closely related to the concept of reputation, Lundgren (2003) and Kristrm and Lundgren (2003) formally introduce goodwill capital in a microeconomic setting of the socially responsible firm. While Lundgren (2003)

concentrates on uncertainty in goodwill evolution and the timing of abatement investment, Kristrm and Lundgren (2003) develop a model where

voluntary abatement investments (one dimension of CSR) create a stock of

goodwill capital that enables the firm to differentiate their product. Other

product differentiation models connected to green consumerism include

Eriksson (2004) and Rodriguez-Ibeas (2007).

In our view, the most comprehensive and complete theoretical discussion

can be found in Heal (2005, 2008). Using a non-formal model he discusses

CSR from both economic and financial perspectives, and proposes how it is

reflected in financial markets. He discusses several cases in relation to CSR.

Heal defines CSR as actions to reduce externalized costs and/or to avoid

distributional conflicts. He suggests that there may be a resource allocation

role for CSR programs in cases of market failure through privatesocial cost

differentials. Furthermore, he argues that in sectors where social and private

costs are not in line, or where distributional conflicts are common, CSR can

play a valuable role in ensuring that the invisible hand acts, as intended, to

produce the social good. It can also act to improve corporate profits and

guard against reputational risks.

In light of the condensed review of theoretical studies on CSR presented

here, we conclude that this type of analyses are on the rise. However, to our

knowledge, a formal dynamic microeconomic model of the firm that

accounts for several dimensions of CSR, in terms of both different types of

CSR and the various drivers and mechanisms, is non-existing. Paul R.

Portney, in Hay et al. (2005), points out that despite a vast amount of

empirical studies of CSR, very few, if any, have derived testable hypotheses

from an adequate theoretical model of the firm. Moreover, few studies clearly

identify the basic mechanisms of how socially responsible behavior leads to

a economic/financial advantage. Portney provides a general outline of how

such a model might work: by engaging in CSR, output price (price differentiation), wages (higher worker productivity or lower wages through worker

satisfaction), and the cost of capital (risk reduction due to lower risk of

73

Thus, profits would not depend solely on the cost of engaging in CSR, but

also on the benefits (Hay et al., 2005, p. 114). The purpose of this paper is to

build such a model within a dynamic framework and explore its properties.

To our knowledge, this is an original exercise and a contribution to the

theoretical literature on CSR.

The paper is organized as follows. In the next section, we present a dynamic

model of CSR. In section 2.1 we propose relevant benefits and costs of CSR,

introduce intertemporal features, and explicitly model goodwill capital as the

driving force for benefits. Sections 2.2 and 2.3 discuss the model properties and

establish the existence and characteristics of a stable equilibrium. In section 2.4

we offer insights from comparative statics and dynamic back-of-the-envelope

analysis. We then proceed to link some of the hypotheses that can be derived

from the model to the empirical literature on CSR. Finally, we offer some

concluding comments and suggestions for future research.

This section outlines and discusses a firm-level model that sheds light on the

potential mechanism behind CSR. The model proposes that with stakeholders

(e.g. consumers, financial sector, government, employees, etc.) rewarding

CSR behavior, the cost of CSR may be balanced by benefits in terms of higher

profitability (see, for example, McWilliams and Siegel, 2001). Indirectly, we

are assuming that the firm is socially responsible for strategic reasons, i.e. it is

good business, or at least not bad business. The analysis relies on dynamics,

a pertinent feature of CSR since it potentially has effects on reputation or

goodwill, which has inherent intertemporal properties. Specifically, we assume

the notion of goodwill capital as a stock that acts upon a firms revenues and

costs in different ways. An intertemporal setting is reasonable when dealing

with CSR investments and goodwill capital. CSR projects build goodwill

capital over time, which can be seen as an intangible asset, a form of reputation. The reputational implications of CSR are highlighted and discussed in

detail in McWilliams and Siegel (2001, 2002), especially the potential effects

of asymmetric information about product attributes and firm activities. In

the model presented here, we abstract from the complications of asymmetric

information. That is, the activities of the firm and the product attributes are

perfectly transparent and known to the consumer.6

6

An asymmetric information case is investigated in Spremann (1985). He provides an interesting advertising model set-up that accounts for asymmetry of information. Advertising can be

Tommy Lundgren

74

The notion of goodwill or reputation as an intangible asset is used extensively in dynamic models of advertising.7 Assuming CSR efforts are signaled

(advertised) appropriately to the market, CSR investment projects can potentially provide the firm with various benefits. We discuss these benefits below

using a model based on the green firm framework developed in Kristrm and

Lundgren (2003), which, in turn, are inspired by advertising models such as

Dorfman and Steiner (1954), Nerlove and Arrow (1962), Gould (1970) and

Jacquemin (1973).

2.1

costs of CSR.

Three main benefits of CSR are assumed:

B1. Consumers reward CSR efforts by a price premium (product differentiation), or (equivalently) by buying more at the same price. Thus, all else

equal, this leads to increasing revenues and profits for the firm (see, for

example, Blend and Ravenswaay, 1999).

B2. Wage is to some degree endogenous to the firm; i.e. people are willing to

accept lower wages to work at a CSR firm, or work more productively at

the market wage rate (see, for example, Bolvig, 2005). This assumption

is based on the notion that employees may experience a warm glow

feeling when working at a socially responsible firm.

B3. Cost of capital is reduced because the financial sector, banks and portfolio managers, etc., assign lower risk to a socially responsible firm (see,

for example, Heinkel et al., 2001; or Godfrey, 2005). The reason is a

lower probability of conflict with stakeholders and various interest

groups in the future (Heal, 2008, provides an extensive discussion of how

CSR can work as a risk management tool).

It is certainly possible to think of other potential benefits. For example,

utility or warm glow from CSR experienced by firm owners (or investors)

and the potential impact on corporate strategies are not considered explicitly

used to signal product quality, augment reputation and increase sales, while consumer goodwill

is a consequence of actual experience of the product. This enables the firm to boost reputation

and sales with advertising in the short run, but over the long run greenwashing becomes an

unsustainable strategy; reputation is damaged if the product does not live up to its expectations.

7

For excellent reviews of quantitative advertising models see Sethi (1977) and Feichtinger et al.

(1994).

75

here.8 Furthermore, societal benefits from CSR are not considered because

our model maintains a firm perspective. Based on a review of the CSR

literature, B1B3 are the main benefits that emerge as the usual suspects

when trying to rationalize socially responsible behavior at the firm level.

The costs of CSR are sorted into three categories:

C1. Actual investment costs in CSR projects. Whether it is an environmental

project or a project related to human rights, there is always an investment cost of engaging in such projects. This cost is assumed to be linear

in the amount of CSR.

C2. Costs of promoting (advertising) CSR investments to stakeholders

(see, for example, Wang, 2008). Without stakeholders knowledge of a

firms socially responsible behavior, the benefits cannot be fully realized.

Together with the project investment cost (as suggested in C1), these

constitute the unit cost, or price, of CSR investments.

C3. Costs that stem from crowding-out effects of CSR. Productive investments and/or production are held back to give room for CSR (for a

discussion of the environmental investments case, see Gray and Shadbegian, 1998). We assume that CSR may hamper conventional firm

activities, and that this cost is increasing at an increasing rate in CSR.9

2.2

The model

general form. Define instantaneous profits of a firm, P, at time t as

= ( g, G , H *) = R (G , H *) C (G , H *) A( g )

(1)

The right-hand-side terms represent revenues and costs. The first two terms

functions depend on the goodwill stock, G, and a set of parameters given by

H*, which are exogenous to the firm. We can think of H* as representing

inputs such as labor and capital that have been chosen optimally at a previous stage and are taken as given.10 This means we can abstract from H* in the

sequel, and thus focus solely on the intertemporal problem involving investment in CSR and the goodwill stock. The last term in the profit function,

8

Similar to the notion of adjustment costs in capital formation analysis.

10

The model could include these inputs as control variables, and potential links to CSR

investments and goodwill, but we keep our approach simple to capture and convey the essential

features of a socially responsible firm.

9

Tommy Lundgren

76

variable we here consider to be one-dimensional. More realistically, the

control variable could be defined as multidimensional, as CSR can take many

forms. However, to simplify, we treat CSR investment as a one-dimensional

control variable.11 This does not change the basic idea we want to convey

here, but simplifies our notation.

For the revenue function we assume that12

R ( 0 ) = R = revenue with zero goodwill stock

(2)

goodwill the firm can increase revenue, but at a decreasing rate.

For the cost function we assume that

C = C (G ) = C [w (G ) , q (G )]

(3)

where

wG < 0, wGG > 0, qG < 0, qGG > 0

w ( 0 ) = w = market wage rate

q ( 0 ) = q = cost of capital with zero goodwill

so that

C ( 0 ) = C = production costs with zero goodwill stock

Costs are decreasing at a decreasing rate in G, due to the beneficial effects on

the wage rate and cost of capital. Both these effects are decreasing at a

decreasing rate, meaning that the firm cannot run the price of labor and

capital to zero by investing in goodwill.

For the CSR cost function we assume that

11

12

Let subscripts denote partial derivatives from hereon.

(4)

77

A(g) is the total cost of investing in CSR, including promotional costs and

crowding-out costs. Crowding out means that CSR takes resources from

other productive activities at an increasing rate (since Agg > 0). This suggests

that small investments in CSR are relatively cheaper than large investments

as a result of convexity in A(g).

Our assumptions about functional forms govern how revenues and costs

are affected by CSR investments, g, and goodwill, G, and ultimately the

behavior of the firm. Let us now introduce dynamics into this setting.

Given the above functional forms, the value function for the management

problem is written as

V = max e rt[ R (G ) C (G ) A ( g )] dt

g

(5)

where V is the value function at time t, and e-rt is a discount factor where r is

the firm discount rate.13 Note that V is also the value of the firm since it is

defined as the perpetual discounted stream of profits. The management

problem is to chose g to build G as to maximize the future stream of discounted profits, given an equation describing how goodwill evolves over

time. In general, it is assumed that goodwill develops over time according to

the following relationship:

G = f ( g, G )

G (t = 0 ) = G0

(6)

where G

current goodwill capital level into changes in goodwill. G0 is a given starting

value for goodwill at time t = 0. We put no sign restriction on G in general or

the starting value G0. Negative goodwill can be considered badwill and is

detrimental to profits (it implies a negative premium on price, and a positive

premium on the wage rate and the cost of capital). Assume the following

properties of the equation of motion specified in (6):

f = f ( g, G )

fg > 0, fgg 0,

fG < 0,

13

fGG 0

(7)

More realistically, we could make the discount rate r also depend on goodwill; i.e. should the

perceived risk of the firm decrease through investment in CSR, then, as a consequence, the rate

of return, which is closely related to the firm discount rate, should also decrease. As a consequence, the value of the firm also changes. However, the inclusion of this mechanism creates a

substantial increase in model complexity. Therefore, we opt to leave this exercise for future

analysis.

Tommy Lundgren

78

Investment in CSR has a positive effect on the change in goodwill. This effect

is either decreasing or linear with magnitude of g. Further, fG < 0 means that

the higher the level of goodwill, the smaller the relative change in goodwill,

ceteris paribus. No assumptions, at this point, are made concerning the

cross-effects between g and G. The following equation of motion for goodwill

is reasonable and easy to work with:

G = g G

(8)

rate of depreciation in the goodwill stock (exponential decay). The efficiency

parameter reflects the ability to transform CSR into goodwill stock. The

depreciation of goodwill over time, if not maintained, can be interpreted as if

stakeholders tend to forget about the firms historical social responsibility. It

could also be interpreted as an effect of other firms investing in CSR, and

therefore deflating the goodwill of this particular firm (as a particular firm is

becoming more similar to other firms, the product differentiation effect gets

less pronounced).

Using equation (5) together with (8), we construct the current value

Hamiltonian,

H c = R (G ) C (G ) A ( g ) + ( g G )

(9)

where l is the adjoint variable or shadow price of goodwill. The shadow price

of goodwill represents the theoretically correct price of goodwill should it be

traded in a competitive market. That is, l is closely related to the marginal

cost of investing in goodwill (as we shall see below).

The optimal conditions given by the maximum principle are

H gc = 0

(10)

= r HGc

(11)

lim (t ) = 0

(12)

The first two conditions must hold along the optimal path. The third condition is a transversality condition associated with infinite horizon autonomous

problems and is needed to provide a boundary condition at the limit.14

Equation (10) can be written

14

The boundary condition is typically replaced by the assumption that the optimal solution

approaches a steady state and settles down (Kamien and Schwartz, 1991, section 9).

Ag + = 0

A

= g

79

(13)

which simply states that the shadow price of goodwill is equal to the marginal

cost of investing in CSR normalized with the efficiency parameter. Expanding the optimal condition (11) yields

= r ( RG CG )

= ( r + ) ( RG CG )

(14)

which is the differential equation for the shadow price of goodwill. Now we

can use (13) and (14) to extract the differential equation for CSR investments,

g. First, take the time derivative of (13), i.e. = Agg g , and substitute the

result for in (14), then substitute l for Ag/a in (14). After isolating changes

in CSRg on the left-hand sidewe have the following differential equation

for CSR investments:

(+)

(+)

Ag

(r + )

( RG CG )

g =

Agg

(15)

(+)

The development over time for g is a function of both g and G. From (15) we

see that the difference between marginal costs and marginal benefits governs

changes in CSR investments over time. We see that if

Ag RG CG

(r + )

g 0

(16)

This suggests that CSR investment/disinvestment will occur when the discounted marginal benefits are smaller/larger than the marginal cost of investing in one extra unit of CSR. This means that when marginal costs are

larger/smaller than marginal benefits, the firm invests/disinvests to the point

where benefits equal costs.

= 0 (and = 0). Assuming

The system is in steady state when g = 0 and G

that the efficiency parameter a = 1, then

Ag =

RG CG

(r + )

(17)

Tommy Lundgren

80

g = G

(18)

The marginal cost of investing in one extra unit of CSR is equal to the

benefits associated with the goodwill it creates, instantly and in the future,

discounted by the rate of return plus the rate of depreciation of goodwill.

According to (18), the level of goodwill is kept unchanged if the firm invests

an amount of CSR equal to the decay of goodwill.

2.3

When certain concavity conditions are satisfied for the Hamiltonian, the

conditions in (10), (11) and (12) are sufficient for maximization (see, for

example, Mangasarian, 1966; Kamien and Schwartz, 1971; or Arrow, 1998).

In short, these conditions require that the current value Hamiltonian is

concave in g and G, jointly, implying that the Hessian of the current value

Hamiltonian is negative semi-definite. The Hessian can be written

c

H gg

H c

Gg

c

H gG

Agg

=

c

HGG 0

RGG CGG

(19)

Since both terms in the diagonal are non-positive by assumption, the Hessian

of the current value Hamiltonian is negative semi-definite in the arguments g

and G, and thus there exists an interior solution, which is a maximum.

Let us portray the steady state in a phase diagram. It is now convenient to

use (14) together with (18). Note that using the differential equation for g will

generate the same qualitative results and conclusions since g is proportional

to l. Setting = 0 in (14) and isolating l on the left-hand side gives the locus

for the co-state in steady state,15

RG CG

r +

(20)

The right-hand side depends only on G, and since R is increasing and concave

in G, and C is decreasing and convex in G, the term (RG - CG) is decreasing

and convex in G. Around G = 0 the term (RG - CG) tends to infinity, and the

locus = 0 is not well defined at this point. The locus for the state variable,

= 0, is given by g - dG = 0 (with a = 1), which implies a linear curve with no

G

15

The locus for g = 0 would look very similar, Ag = (RG - CG)/(r + d). Assuming a quadratic

function for A(g) implies that the locus for g = 0 is proportional to the locus for = 0, so the

qualitative results would be the same whether we use either locus in our phase diagram.

81

transformation of l, the locus g - dG = 0 can be written h(l) - dG = 0, where

g = h(l) and h-1(g) = l.16 Plotting the loci in the [l, G]-space generates the

we can easily verify, for

curves in figure 1. Studying the partials of and G

/l > 0

the functional assumptions at hand, that > 0, G > 0 , G

and G/G < 0, which gives the directional arrows depicted in figure 1.

The equilibrium is a maximum and is given by l* and G* with a stable

branch leading into it from both left and right. It is easy to formally show that

this equilibrium is a saddlepoint maximum. See the Appendix for details.

2.4

investment behavior (comparative statics) and some back-of-the-envelope

dynamic analysis. The steady-state analysis is standard. The derivation of

= 0,

The slopes of the loci are given by the partial l/G conditional on = 0 and G

respectively.

16

Tommy Lundgren

82

Caputo (1990a, 1990b).17 We begin by parameterizing the model.

2.4.1

Model parameterization

capital and labor,

max = pY ( K , L ) wL qK

K ,L

(21)

where p , w and q are market prices for output, labor and capital, respectively. Y(K, L) is a production function with capital and labor as arguments.

This gives us L* and K*, the optimal levels of labor and capital.18 Next, the

firm maximizes profits with respect to investment in CSR and building to a

stock of goodwill capital. At this stage L* and K* are taken as given.19 The

CSR management problem is written

V ( ) = max e rt ( ) dt

0

0

G = g G

G ( 0 ) = G0

(22)

where w is a vector of parameters.20 Assume the following parametric specification for the functions p(G), w(G), q(G) and A(g):

w(G ) = w ln G , with > 0

q (G ) = q ln G , with > 0

1

A( g ) = ( p csr + padv ) g + g 2, with > 0

2

= ( p, w, q , , , , p csr, padv, , , , r, G0 )

(23)

These functions have the desired properties stated in the previous section (see

(2), (3) and (4)); i.e. there exists a steady-state saddlepoint equilibrium, which

is a maximum. The output price, wage and cost of capital functions are

17

See also, for example, Oniki (1973) for a similar methodology. Caputo (1990b) contains a

general discussion of comparative dynamics in optimal control problems.

18

Compare with the H* in (1).

19

The problem would be considerably more complex if we include K and L as controls, without

really adding relevant richness to the analysis.

20

All parameters are non-negative.

83

specified so that they depend on the exogenously given market rate and an

endogenous premium determined by a parameter and goodwill capital. The

CSR cost function consists of a linear part that depends on the price of CSR

and the price of promoting CSR, and a non-linear part that represents costs

that occur due to crowding-out effects.

2.4.2

First, let us look at the steady-state CSR investment behavior of the firm.

Recall that from the steady-state conditions in (17) and (18) we have

Ag ( g*) RG (G *) CG (G *)

=

r +

g* = G *

(24)

where g* and G* are steady-state levels of CSR investments and the goodwill

stock. Given the functional forms specified and parameterized in (23) we can

write

1

(Y * + L* + K *)

p csr + padv + g* G *

=

r +

(25)

a ( g*) + bg* + c = 0

2

(26)

where

a =1

b=

p csr + padv

c=

Y + L + K

r +

()

Solving for g* yields the following expression for the steady-state level of

CSR investments and the goodwill stock:

g* =

1

b 4ac + b2

2a

Tommy Lundgren

84

G* =

b 4ac + b2

2a

Given a, b and c we can expand and cancel terms so that the steady-state

conditions become21

2

1 p csr + padv

1

Y * + L* + K * p csr + padv

4

2

2

r +

G * = g*

g* =

()

(27)

value do not affect the level of steady-state rate of CSR investments, i.e.

g*/a = 0. However, if a = 0, the firms investment in CSR will be zero, since

it cannot convert CSR efforts into goodwill at any investment rate. The stock

of goodwill, G*, is proportional to the efficiency parameter, i.e. its steadystate level is directly affected by changes in the parameter a.22 The signs of the

partial derivatives for g* and G* are obvious for the premium parameters, e,

q, g, and the discount rate, r, but it is less straightforward to assess in the case

of the rate of depreciation in goodwill, d, the price of CSR, pcsr, the price of

promoting CSR, padv, and the crowding-out parameter, b. It is easily verified

that g*/d > 0 and G*/d < 0. This means that the higher the rate of depreciation in goodwill, the more the firm will have to invest in CSR to maintain

it. However, ceteris paribus, an increase in the depreciation rate decreases the

goodwill stock. Furthermore, we can derive the following partials for the

price of CSR and price of promotion/advertising:

g*

g* ( p csr + padv )

= adv =

csr

p

p

2 2

G * G * ( pscr + padv )

=

=

2

p csr padv

(28)

( r + ) ( p csr + padv ) + 4 (Y * + L* + K *)

=

>0

2( r + )

2

determined by the term (pcsr + padv) - bY, which is negative for reasonable

21

Note that only the negative root makes sense in this case.

An increase in a would simply scale the stock of goodwill upward since CSR now adds more

goodwill per unit invested.

22

85

crowding-out parameter are derived as

=

2 3( r + )

2 (Y * + L* + K *)

2 3( r + )

G * g*

=

(29)

which both have negative signs (for reasonable parameter values), as one

would expect.

2.4.3

relevant parameters associated with CSR investments and the goodwill stock.

This is different from the previous exercise that analyzed CSR investment

behavior around the steady state. Instead, we now look at dynamic properties, i.e. we explore the partial effects on firm value over the whole planning

horizon using a back-of-the-envelope approach.

Consider the envelope properties of value function, V(w). The dynamic

envelope theorem postulates that the first partials of V(w) are found by (i)

differentiating the Hamiltonian for the optimal control problem directly with

respect to the parameters of interest, (ii) holding the state, co-state and

control fixed, then (iii) evaluating the partials along the optimal paths for

these variables, and (iv) finally integrating the result over the planning

horizon (Caputo, 1990b). This implies we can differentiate the Hamiltonian

directly with respect to parameters prior to substituting in the optimal

trajectories.

Write the present value Hamiltonian23 as

H = e rt[( p + ln G )Y ( K *, L*)]

e rt[(w ln G )L* ( q ln G )K *]

1

e rt ( p csr + padv ) g + g 2 + ( g G )

(30)

23

Here we follow Caputo (1990b) and work with the present value Hamiltonian instead of the

current value Hamiltonian. This is convenient and enables us also to explicitly investigate the

effect of changing the discount rate, r.

Tommy Lundgren

86

for the parameter e generates

H = e rt ln GY *

H optimal path = e rt ln G * (t; )Y *

(31)

0

(32)

That is, if the output markets sensitivity with respect to the firms goodwill

increases, then the value of the firm also increases. Since goodwill creates a

price premium whose size is determined solely by the parameter e, it comes

as no surprise that Ve(w) > 0. The same procedure for the other parameters

gives us

0

Vw ( ) = e rt L*dt < 0

0

Vq ( ) = e rt K *dt < 0

0

0

0

0

0

(33)

(34)

(35)

(36)

(37)

(38)

(39)

24

The derivation of this convenient result in Caputo (1990b) is rather lengthy and involved. A

much neater and less rigorous derivation is found in Aronsson et al. (2004, ch. 9). The trick is to

introduce an artificial state variable in terms of the parameter of interest (in their case it

represents a project). Assume we want to examine the project a. Then the co-state dynamics

is represented by = 0, a(0) = a. The co-state variable or shadow price of a is la = V/a. It

is now easy to show from the co-state optimal condition (co-state equation) that

1 rt

2

e [ g* (t; )] dt < 0

0

2

V ( ) =

0

0

Vr ( ) = te rt ( ) dt < 0

0

87

(40)

(41)

(42)

(43)

Let us briefly comment on the partials portrayed in (33)(43). All partials are

unambiguously signed. None of the derived signs of the partials comes as a

surprise, since the Hamiltonian was carefully rigged to meet the conditions

necessary for a saddlepoint equilibrium. Note that these dynamic envelope

results recover cumulative discounted functions, and not instantaneous functions as with static envelope analysis. Vq(w), Vg (w) > 0 implies that should the

parameters governing the size of the premiums on wage and cost of capital

increasei.e. employees and capital markets become more sensitive to

CSRthen the value of the firm moves in the same direction. If price of CSR

and price of promoting CSR go up, Vpcsr ( ) , Vpadv ( ) < 0 , then, not surprisingly, the firm value decreases. Crowding-out effects are measured by the

parameter b. Since Vb(w) < 0, one can conclude that more severe crowdingout effects will lower the value function and thus firm value. Efficiency in

converting CSR efforts into actual goodwill is measured by the parameter a;

i.e. should a increase, the firm becomes more efficient in transforming CSR

policy into goodwill, and from Va(w) > 0 we see that the value of the firm also

increases.25 An increased depreciation rate of goodwill, d, or discount rate, r,

has a negative impact on firm value, Vd (w), Vr(w) < 0.

Another useful dynamic result that can be derived from optimal control

theory is that the change in the value of the firm is directly related to the

change in goodwill. This comes from a general result in optimal control (see,

for example, Brock, 1998), where the time derivative of the value function in

a dynamic optimal control problem is directly related to the net changes in all

stocks in the model in the following way:

V = i Si

i

25

(44)

Note that the comparative statics showed that in equilibrium, the CSR investment rate is not

affected by changes in the efficiency parameter. However, the dynamic long-run effect on firm

value associated with a change in the efficiency to convert CSR investments into goodwill is

unambiguously positive.

Tommy Lundgren

88

where li is the shadow price of stock i, and Si is the ith stock. Since the present

control problem has only one stock, goodwill, we can write

V = G

(45)

This result suggests that all changes in goodwill, positive or negative, as a result

of investing or disinvesting in CSR, will have direct effect on the value of the

firm given that there is a non-negative shadow price of goodwill capital.26

The model presented in this paper can help grasp how empirical hypotheses

concerning CSR can be derived in a consistent way, without having to

resort to speculation or poorly undermined reasoning. Here we identify

some possible hypotheses drawn from the model framework and then look

into whether the empirical literature on CSR supports or refutes them. The

purpose of this exercise is to point out the usefulness of the model presented to facilitate the understanding of the drivers behind CSR and, consequently, how to build testable hypotheses consistently.27 It also reveals

that our model encompasses many of the known and tested features of

CSR.

H1: CSR behavior that increases goodwill may have a positive effect on output

price: P(G)/G > 0.

Is there a price premium for CSR firms? Just a cursory look around

suggests this, e.g. actual forest product price lists suggest that certification

of forest products leads to higher price. Kristrm and Lundgren (2003) find

evidence of a price premium for green pulp in Swedish pulp industry.

Furthermore, empirical results in Blend and Ravenswaay (1999) suggest

that American consumers are willing to pay a premium for eco-labeled

apples, but not too much. Similar examples from the literature abound.

H2: CSR efforts that increase goodwill may have a beneficial effect (i.e. negative) on the wage rate: w(G)/G < 0.

Empirical evidence of wage differentials for CSR firms are scarce. Bolvig

(2005) finds evidence of compensating wage differentials in CSR firms in a

26

This relationship is (implicitly) the most widely tested in the empirical literature on social

performance and financial performance. More on this below.

27

Bert Scholtens is thanked, without being implicated, for suggesting this section.

89

employee satisfaction and long-run stock performance by reviewing a portfolio of stocks selected by Fortune magazine as the Best Companies to Work

For in America in 1998. The study finds the portfolio earned more than

double the market return, which would suggest that employee satisfaction

improves corporate performance.

H3: CSR efforts that increase goodwill may have a beneficial effect on the cost

of capital: q(G)/G < 0.

By engaging in CSR, the firm signals a probability of less conflicts in the

future, and thus a more ambitious risk management strategy, which lowers

the specific risk that capital markets assign to the firm. The empirical evidence supporting the connection between cost of capital and CSR is scarce.

Hart and Ahuja (1996) find empirical evidence in the USA that the cost of

capital decreases, and thus firm value increases, following good environmental performance. Derwall and Verwijmeren (2006) find in a US sample that

environmental performance and corporate governance have a negative effect

on the cost of capital, while human rights issues increase the cost of capital.

The net effect is ambiguous. Sharfman and Fernando (2008) study 267 US

firms and show that improved environmental risk management is associated

with a lower cost of capital.

H4: CSR investments cause crowding-out effects: A(g)/g < 0.

Kristrm and Lundgren (2003) try to measure crowding-out effects due to

abatement investments in the Swedish pulp industry during the period 1985

90, but statistical analysis does not show such effects. Gray and Shadbegian

(1998) find evidence that environmental investments crowd out other productive investments as follows: a 1 per cent increase in environmental investment

causes a 1.88 per cent decrease in productive investments. Similar evidence is

found in an earlier study by Barbera and McConnel (1986), who find that

abatement investments retard capital and labor productivity and hence

impose an extra adjustment cost, which, ceteris paribus, lowers profitability.

H5: Change in firm value is positively affected by changes in goodwill:

V/t = lG/t.

The bulk of the empirical work can be found within this category. Margolis

and Walsh (2001) or Hay et al. (2005) both provide excellent reviews. The

results are somewhat ambiguous. However, as mentioned in the introduction,

most studies show a positive relationship between firm value and different

90

Tommy Lundgren

i.e. mainly positive results are submitted and subsequently published. But a

certain amount of heterogeneous results would be expected according to the

model presented here. The model predicts that some firms will be positively

affected by engaging in CSR, while others will not. The expectation of

heterogeneous results is attributed to whether such behavior is rewarded or

punished by a firms stakeholders. The existence of a goodwill capital stock is

solely dependent on whether the stakeholders care about firm social behavior.

In summary, it is not difficult to find empirical evidence for some of the

hypotheses that can be derived from the model framework presented here.

However, the current literature lacks a joint test of several of the hypotheses

listed above.28 For example, consider a firm that experiences crowding outcosts due to environmental investments. Does this firm also reap the benefits

in terms of an output price premium, and/or cost reductions via compensating wage differentials, and/or lower cost of capital due to effects via ambitious environmental risk management?

4. CONCLUDING REMARKS

This paper provides theoretical underpinnings to help understand the mechanisms and incentives behind the behavior of a socially responsible firm.

Profit-maximizing firms consider both the costs and benefits of CSR. The

implications of these findings are that firms will engage in CSR activities if

stakeholders, such as the government, the financial sector, consumers, nongovernmental organizations, etc., reward or pressure firms to engage in such

behavior. The link between profitability and different dimensions of CSR is

therefore likely to differ across countries, sectors and even firms. The model

in this paper provides a useful theoretical background for the understanding

of CSR incentives and for constructing relevant hypotheses in empirical

applications.

Future research should include the impact of uncertainty, e.g. what are the

effects of environmental incidents or bad news that arrive over time in some

stochastic manner? A natural way to model this would be to include a

stochastic element to the evolution of goodwill capital, e.g. an Ito diffusion

process and/or a Poisson jump process.29 Another possible route of research

28

Although H5 can be considered a kind of overall test of whether social performance is

associated with higher firm value.

29

The models in, for example, Tapiero (1977, 1978) could be adapted and modified to tell the

story of CSR under uncertainty. See also Lundgren (2003) for an Ito/Poisson process applied to

the evolution of goodwill in a highly simplified investment optimal stopping problem.

91

would be to allow for potential Porter effects where some types of CSR

investments (e.g. investment in green technology) could have positive effects

on long-term efficiency of the capital stock and/or spur innovative processes

and investment in R&D. This could be modeled within the framework presented here, possibly combined with uncertainty components. It would also

be useful to explore the consequences of asymmetric information further;

that is, when reputation and sales can be boosted with advertising efforts

(see, for example, Spremann, 1985) without actually altering the product

attributes, so-called greenwash.

APPENDIX

In infinite horizon autonomous problems with one control and one state

variable, and when the discount rate is small enough, the equilibrium is

usually a stable saddlepoint (Kamien and Schwartz, 1991, section 9).

However, this is more of a rule of thumb than a mathematical certainty. In

general, the steady state may or may not exist, or there may be multiple

steady states. To characterize the equilibrium formally, we now proceed to

study the linear differential system that approximates (6) and (11).30 Again we

work with the differential equation for l instead of g. Since g is proportional

to l, compare (14) with (17), the qualitative results will be the same. Write the

Hamiltonian in general form as

H c = ( g , G ) + f ( g , G )

(A1)

H gc = g ( g, G ) + fg ( g, G ) = 0

(A2)

and

c

H gg

<0

(A3)

Recall that

= r HGc ( g, G , )

(A4)

g = u (, G )

(A5)

Now totally differentiate (A1) and (A5) to get the properties of u(l, G):

30

Tommy Lundgren

92

c

c

dH c = H gg

dg + H gG

dG + fg d

(A6)

dg = uG dG + u d

(A7)

c

H gG

fg

dg = c dG c d

H gg

H gg

(A8)

uG =

c

H gG

fg

, u = c

c

H gg

H gg

(A9)

G = f (u ( , G ) , G ) , G ( 0 ) = G0

= r HGc (u ( , G ) , G , )

(A10)

f (u ( *, G *) , G *) = 0

r H (u ( *, G *) , G *, *) = 0

g* u ( *, G *) = 0

c

G

(A11)

expansion approximation of the system given by (A10) around l* and G*:

G = ( fG + fg uG ) (G G *) + fg u ( *)

c

c

c

= ( HGG

+ HGg

uG ) (G G *) + (r fG HGg

u ) ( *)

(A12)

G = a (G G *) + b ( *)

= c (G G *) + (r a ) ( *)

(A13)

c

c

c

c

c

H gg

, b = ( f 2 g H gg

where a = fG fg H gG

.

H gg

) and c = ( HGgc ) H ggc HGG

The characteristic equation and roots for the system (A13) are

2

m2 rm + a (r a ) bc = 0

1

r (r 2a ) + 4bc 2

m1, m2 =

2

2

2

(A14)

93

If the roots are real, then the larger root is positive. The sign of the smaller

root is either positive or negative. It is negative if

bc > a (r a )

or

(+)

2

f g c 2

c

c

HGG

c ( HGg ) H gg

H

gg

c

H gg

()

c

c

f

H

fg H gG

g

gG

> fG

r

f

G

c

c

H gg

H gg

If this holds, the roots are real and of opposite sign, and the steady state

satisfies the conditions to be a saddlepoint. It is easy to verify that for the

functional properties assumed in our model, this condition indeed holds.

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Tommy Lundgren

Centre for Environmental and Resource Economics

Ume School of Busniness

S-901 87 Ume

Sweden

E-mail: tommy.lundgren@usbe.umu.se

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