Corporate Social Responsibility and Firm Performance

1. Corporate Social Responsibility andFirm Performance Abagail McWilliams Professor of Management University of Illinois at Chicago

2. Presentation Outline • Critique of existing empirical studies of the effect of CSR on firm performance • CSR - Supply and Demand Framework • Hypotheses pertaining to the provision of CSR attributes across firms/industries • Strategic Implications of CSR – Using preemptive strategies that rely on CSR reputation

3. Corporate Social Responsibility (CSR) • Do socially responsible firms outperform or under-perform other firms that don’t meet the same social criteria? • Precisely how should firms allocate resources to CSR? Most management researchers address Question #1, not Question #2

4. Methods Used to Assess the Impact of CSR on Firm Performance Event Studies: As shown by McWilliams & Siegel (1996, 1997a, 1997b, 1998, 1999), these studies are typically poorly designed and executed  spurious results Regression Analysis: As demonstrated by McWilliams & Siegel (2000) these studies may suffer from specification error biased results (see Appendix I)

5. Firm Profitability: Neutral relationship between investment in CSR and firm profitability Capital Market Evidence: Returns on “socially screened” portfolios are roughly the same as the returns on (actively managed) “unscreened” portfolios CSR has a neutral effect on firm performance (on average) for a broad cross section of firms The need for a new theoretical perspective Empirical Evidence: CSR has a Neutral Impact on Performance

6. Theoretical Perspectives on CSR in the Management Literature • Agency Theory (Friedman, 1970) • Stakeholder Theory (Freeman, 1984) • Resource-Based Theory (Russo and Fouts, 1997) • Theory of the Firm/Supply and Demand Framework (McWilliams and Siegel, 2001)

7. CSR: Definition Corporate Social Responsibility - Actions taken by a firm that appear to further some social cause, beyond the interests of the firm and that which is required by law and ethics. Examples: goods and services with “social” characteristics (e.g., organic produce) or managerial practices that promote a social objective, such as “progressive” HRM practices

8. CSR: Supply and Demand/Market Framework (see Appendix I) Consumer Demand Creation of new product categories: “Organic” produce “Made in America” apparel “Dolphin-Free” tuna Mix of Product and Process Innovations Each CSR characteristic is valued by some consumers (and possibly by other stakeholders as well), that is, some consumers are willing to pay extra for these attributes

9. Supply and Demand/Market Framework (cont.) Investor Demand for CSR Socially Responsible Investing: Mutual funds that employ various social screens Additional Stakeholder Demand for CSR Workers, suppliers, government, and the community

10. Supply and Demand Framework (cont.) Search, Experience, and Credence Goods: (Nelson, 1970, 1974; Darby and Karni, 1973) Search goods: Products whose attributes and quality can be determined before purchase - clothing, tomatoes Experience goods: Products whose quality can only be determined after purchase - processed foods, software programs, new models of cars Credence goods: Products whose quality cannot be determined even after purchase - education, consulting, financial planning Key point: Reputation is more important for experience than search goods and most important for credence goods

11. Hypotheses Based on Supply and Demand Framework Demand-related Hypotheses: H1: Given that consumers rely more on firm reputation when purchasing experience and credence goods, these are more likely to have CSR attributes than search goods. H2: Because consumers must be made aware of the existence of CSR attributes, there will be a positive correlation between the intensity of advertising and the provision of CSR. H3: There will be a positive correlation between a firm’s level of product differentiation and its provision of CSR attributes.

12. Supply of CSR The provision of CSR characteristics entails higher costs because firms must devote additional resources to generate these characteristics (see Appendix II)

13. Hypotheses Based on Supply & Demand Framework (cont.) Supply-related Hypotheses: H4: Firms that provide CSR attributes will have higher costs than firms that do not provide CSR attributes, all else being equal. H5: The presence of scale economies in the provision of CSR attributes results in a positive correlation between the size of a firm and the provision of CSR attributes.

14. Hypotheses Based on Supply & Demand Framework(cont.) Profitability Hypothesis: H6: In general, firms whose products have CSRcharacteristics earn the same rate of return as firms whose products do not have CSR characteristics (unless firms can use CSR to raise entry barriers or rivals’ costs).

15. Market Outcome As a general matter, CSR neither helps nor hurts financial performance CSR could be an integral part of a firm’s differentiation strategy. Thus, it needs to be considered as a form of strategic investment  Cost/Benefit Analysis is useful

16. Research Agenda:Strategic Implications of CSR Strategic Positioning for Competitive Advantage: Reputation Building/Product Differentiation Sustaining Competitive Advantage: Isolating Mechanisms Impediments to Imitation (e.g., Social Complexity) Early Mover Advantages (e.g., Reputational) Preemptive Strategies Using CSR to Raise Rivals’ Costs/Entry Barriers (McWilliams, Van Fleet and Cory, 2002)

17. Preemptive Strategies: Using CSR to Block Alternative Strategies and Resources • Firm A has a resource (e.g., a patented process that lowers the cost of production) • This resource is valuable, rare, and difficult to imitate • But, competitors may achieve similar costs by producing in countries with lower labor costs which may involve unsafe/unhealthy work conditions and/or child labor

18. Preemptive Strategies: Using CSR to Block Alternative Strategies and Resources (cont.) Firm A may attempt block the use of the cheaper “foreign” labor through the use of CSR tactics - by inducing consumers to boycott rivals - by lobbying for trade restrictions or local content requirements

19. Preemptive Strategies: Using CSR to Block Alternative Strategies and Resources (cont.) If successful, blocking the use of substitute strategies or resources will allow Firm A to sustain a competitive advantage or to protect competitive parity (prevent a competitor from creating an advantage). (And will also further some social goal) However, blocking requires resources (e.g., advertising, lobbying), so this again suggests the need for cost/benefit analysis.

20. Preemptive Strategies: Using CSR to Block Alternative Strategies and Resources (cont.) Success of such “blocking” strategies depends on the CSR reputation of Firm A (a credible motive).  a reputation for CSR is valuable in the market Caveat: Such reputations are costly to develop and fragile (can be damaged easily).

21. Proposals for Future Projects on CSR – with Donald Siegel, RPI “Corporate Social Responsibility: A Synthesis of Managerial and Economic Perspectives,” conference/edited volume, under negotiation with MIT Press and Oxford University Press “Interdisciplinary Perspectives on Corporate Social Responsibility,” proposal for a special issue under review at Journal of Management

22. Appendices

23. Appendix I: Methods Used to Assess the Impact of CSR on Firm Performance Econometric Model Used to Assess the Impact of CSR on Firm Performance: Incorrect Specification: (1) Performance = f (CSR, IND, SIZE, RISK) Specification Error: Key Omitted Variable – A Proxy for Investment in R&D Correct Specification: (2) Performance = f (CSR, IND, SIZE, RISK, R&D)

24. Consequences of Specification Error Not a concern when the omitted variable is uncorrelated with included regressor However, dozens of firm and industry-level studies report a strong positive correlation between R&D and proxies for long-term firm performance, that is: corr (R&D, Performance) > 0

25. Consequences of Specification Error (continued) CSR as a form of product differentiation  CSR is correlated with R&D and advertising corr (R&D, Performance) > 0; corr (R&D, CSR) > 0  existing econometric estimates of the impact of CSR on firm performance are upwardly biased In our sample of 524 firms: corr (R&D, CSR) = .45 (see McWilliams & Siegel, 2000, in which we linked Compustat data with KLD data)

26. Regression Results of Equations (1) and (2)(N = 524 firms, Standard Errors in Parentheses) Dependent Variable: Performance Equation Equation (1) (2) Coefficient on CSR .141*** -.062 (.052) (.059) Coefficient on R&D .263*** (.050) Adjusted R2 .10 .29 ***p  .01 Note: regressions include controls for size, risk, advertising, and industry effects

27. Appendix II - CSR: Analytical Model For simplicity, assume there are only two “goods” in the market, that is: Qx = quantity of the good without CSR attribute Qy = quantity of the good with CSR attribute Identical goods, except for the CSR characteristic  Qy = Qx+QCSR

28. Supply and Demand/Market Framework (cont.) Consumer Demand for CSR Qy = f (Py , Px, A, I, T, D) ; where Qy = quantity of the good with CSR attribute Py = the price of the good with CSR attribute Qx = quantity of the good without CSR attribute Px = the price of the good without CSR attribute A = advertising I = income T = tastes and preferences D = demographics

29. Supply and Demand Framework (cont.) Supply of Goods with CSR Characteristics: Qy =Qx+QCSR = f (Kx+ KCSR, Lx+ LCSR, Mx+MCSR,) where: Q = output K = capital L = labor M = materials The provision of CSR characteristics entails higher costs because firms must devote additional resources to generate these characteristics