Socially Responsible Firms
One of the perennial problems in any interaction is the problem of incomplete information. Think about such situations as your first day in class, going on a job interview, buying or selling a car or a house. In each case, you are dealing with someone about whom you have incomplete information. In the case of your first day of class, you’re not quite sure what the professor expects from you. When you go on a job interview you’re not quite sure what the interviewer is thinking about you as you answer the questions. When engaging in the purchase or sale of anything really (not only cars and houses) you are dealing with situations where you have incomplete information. The reason this raises a problem is that in such situations the incentive is to take advantage of the other person in the situation. Just consider the prisoner’s dilemma you dealt with. There was a powerful incentive to betray the other person even though the maximum benefits for each would only come about through cooperation. Robert Frank attempts to show how this situation is relevant to the business world and how it illustrates that socially responsible firms can survive in a competitive environment.
Frank reinterprets the Friedman idea of social responsibility to mean any firm which chooses to cooperate in a prisoner’s dilemma type situation. To clarify this, a prisoner’s dilemma type situation is any case where two people (or entities such as corporations) engage in a transaction one time, for example, when you sell your car through an ad in the newspaper. The buyer and you will only have this one transaction. In this case, there is a powerful incentive for each of you to take advantage of the other. To guard against this each of you will take steps to protect your position but in doing so, each person may end up in a worse position than if you had cooperated. While this situation is not an example of a serious problem in the worst-case scenario you end up not selling your car and the buyer ends up without a car. This would happen in a case where you ask for much more than the car is worth (hoping to take advantage of the buyer) while the buyer claims to only be able to afford a lesser amount (hoping to take advantage of you as the seller).
So, how can there be any chance for cooperation, what Frank calls socially responsible behavior, in such situations? The key is to solve what he calls a commitment problem. To do this, it helps to be able to identify the cooperators and the defectors. Think about it in terms of a simple situation. You live in a society with other people some of whom cooperate and some of whom defect. Say you are in the position of being able to lend someone some money. Suppose you are a cooperator which means you will lend money to someone if they ask you. In return, the deal is that if you need money someone will lend it to you. You have an incentive to lend to other cooperators because you can expect that they will repay the favor if needed. But, a defector will simply take advantage of your generosity and take your money with no intention of repaying you (the money or the favor!). If cooperators and defectors are indistinguishable you are pretty much on your own. Of course, once you discover someone is a defector you won’t make the same mistake twice. But, if you had a clear way of identifying a priori the defectors you would stand a much better chance.
Frank suggests several ways that socially responsible firms can prosper even in situations where there are pressures to defect from agreements. This involves solving certain commitment problems with employees, customers, and other firms. In each case, the solution hinges on reputation. This is a central point in business ethics and one we’ve addressed before in our discussions on truth-telling and will discuss on employment at will. Though individual employees may have incentives to cheat employers and vice versa, the reputational costs of doing so tend to be high. Think about it. If you were looking for a job you wouldn’t want to apply to a company with a reputation for mistreating employees or forcing them out just before they retire to avoid paying benefits. And, as an employer, you would be hesitant to hire someone known to be dishonest.
The same issues hold for relations with customers. When you look through the phone book think about how many businesses advertise how long they’ve been in business using slogans like: In business since 1954. Why do they do that? Well, longevity is one indication of a solid reputation and a way to solve a commitment problem with customers. No one wants to engage in business with a “fly by night” company. Similar problems can be solved with organizations like the Better Business Bureau and Consumer Reports. This is another way for companies to address the commitment problems raised by the incentive to cheat customers.
When you think about how companies relate to one another you can see that similar issues arise. While some companies are in direct competition others are in the relationship of customers. Frank mentions in particular subcontractors but you can think of others as well. In each case “material incentives are inadequate to solve the commitment problems” and so companies need to rely on reputation. In other words, those with a reputation for trustworthiness will be at an advantage in such situations.
Will consumers pay a premium to do business with socially responsible firms? Conventional economic theory suggests that the answer is no, but there are good examples of consumers doing this. The case of Star-Kist Tuna is mentioned as well as Ben & Jerry’s Ice Cream. In these and other cases consumers will pay a premium to support a company that engages in socially responsible behavior there is an incentive to engage in such behavior. Not only will consumers support such businesses but employees will seek out such companies to work for. Studies show that employees will sacrifice some earnings to work for companies with a reputation for socially responsible action. Think about it. If you could land a job earning $50,000 a year working either for a tobacco company or the Red Cross which would you choose? Studies show that a large majority will choose the Red Cross. Now, suppose the Red Cross job only pays $40,000 compared to the $60,000 for the tobacco job? Will that change your answer? At what price would you take the job with a company that has less of a socially responsible reputation? Something to think about!
Frank reinterprets the Friedman idea of social responsibility to mean any firm which chooses to cooperate in a prisoner’s dilemma type situation. To clarify this, a prisoner’s dilemma type situation is any case where two people (or entities such as corporations) engage in a transaction one time, for example, when you sell your car through an ad in the newspaper. The buyer and you will only have this one transaction. In this case, there is a powerful incentive for each of you to take advantage of the other. To guard against this each of you will take steps to protect your position but in doing so, each person may end up in a worse position than if you had cooperated. While this situation is not an example of a serious problem in the worst-case scenario you end up not selling your car and the buyer ends up without a car. This would happen in a case where you ask for much more than the car is worth (hoping to take advantage of the buyer) while the buyer claims to only be able to afford a lesser amount (hoping to take advantage of you as the seller).
So, how can there be any chance for cooperation, what Frank calls socially responsible behavior, in such situations? The key is to solve what he calls a commitment problem. To do this, it helps to be able to identify the cooperators and the defectors. Think about it in terms of a simple situation. You live in a society with other people some of whom cooperate and some of whom defect. Say you are in the position of being able to lend someone some money. Suppose you are a cooperator which means you will lend money to someone if they ask you. In return, the deal is that if you need money someone will lend it to you. You have an incentive to lend to other cooperators because you can expect that they will repay the favor if needed. But, a defector will simply take advantage of your generosity and take your money with no intention of repaying you (the money or the favor!). If cooperators and defectors are indistinguishable you are pretty much on your own. Of course, once you discover someone is a defector you won’t make the same mistake twice. But, if you had a clear way of identifying a priori the defectors you would stand a much better chance.
Frank suggests several ways that socially responsible firms can prosper even in situations where there are pressures to defect from agreements. This involves solving certain commitment problems with employees, customers, and other firms. In each case, the solution hinges on reputation. This is a central point in business ethics and one we’ve addressed before in our discussions on truth-telling and will discuss on employment at will. Though individual employees may have incentives to cheat employers and vice versa, the reputational costs of doing so tend to be high. Think about it. If you were looking for a job you wouldn’t want to apply to a company with a reputation for mistreating employees or forcing them out just before they retire to avoid paying benefits. And, as an employer, you would be hesitant to hire someone known to be dishonest.
The same issues hold for relations with customers. When you look through the phone book think about how many businesses advertise how long they’ve been in business using slogans like: In business since 1954. Why do they do that? Well, longevity is one indication of a solid reputation and a way to solve a commitment problem with customers. No one wants to engage in business with a “fly by night” company. Similar problems can be solved with organizations like the Better Business Bureau and Consumer Reports. This is another way for companies to address the commitment problems raised by the incentive to cheat customers.
When you think about how companies relate to one another you can see that similar issues arise. While some companies are in direct competition others are in the relationship of customers. Frank mentions in particular subcontractors but you can think of others as well. In each case “material incentives are inadequate to solve the commitment problems” and so companies need to rely on reputation. In other words, those with a reputation for trustworthiness will be at an advantage in such situations.
Will consumers pay a premium to do business with socially responsible firms? Conventional economic theory suggests that the answer is no, but there are good examples of consumers doing this. The case of Star-Kist Tuna is mentioned as well as Ben & Jerry’s Ice Cream. In these and other cases consumers will pay a premium to support a company that engages in socially responsible behavior there is an incentive to engage in such behavior. Not only will consumers support such businesses but employees will seek out such companies to work for. Studies show that employees will sacrifice some earnings to work for companies with a reputation for socially responsible action. Think about it. If you could land a job earning $50,000 a year working either for a tobacco company or the Red Cross which would you choose? Studies show that a large majority will choose the Red Cross. Now, suppose the Red Cross job only pays $40,000 compared to the $60,000 for the tobacco job? Will that change your answer? At what price would you take the job with a company that has less of a socially responsible reputation? Something to think about!