Jose Miguel Abito 1 David Besanko 2 Daniel Diermeier 3. April 14,

Transcription

1 Private Politis and Publi Interest: NGOs, Corporate Campaigns, and Soial Welfare (Preliminary and inomplete- Please do not ite without permission) Jose Miguel Abito 1 David Besanko 2 Daniel Diermeier 3 April 14, University of Pennsylvania Business Eonomis and Publi Poliy, abito@wharton.upenn.edu. 2 Northwestern University Department of Management & Strategy, d-besanko@kellogg.northwestern.edu. 3 Northwestern University Department of Managerial Eonomis and Deision Sienes, d-diermeier@kellogg.northwestern.edu

2 Abstrat We provide a model of the interation between a profit-maximizing firm and an ativist. Firms are about their reputation with ustomers, and the reputation of a firm an be enhaned through private regulation, i.e. voluntary ativities that redues a negative externality. Ativists an damage the firm s reputation through orporate ampaigns. The presene of an ativist hanges the reputational dynamis of the game by tending to keep the firm in reputational states in whih it is highly motivated to invest in externality-reduing ativity. We solve for the equilibria of the dynami game and assess the welfare onsequenes of ativist ativities.

3 1 Introdution The regulation of eonomi ativity is one of the main arenas of politial ompetition. The impetus for hanges to regulatory regimes frequently originates with onerned itizens, often motivated by soial or ethial onerns. Traditionally, onerned itizens have used publi institutions suh as legislatures, exeutive agenies, and ourts to advane their agenda. But in reent deades private politis has emerged as a new regulatory mehanism (e.g. Baron 21, Baron 23, Baron 212, Baron and Diermeier 27, Feddersen and Gilligan 21, Ingram, Yue, and Rao, 21, King and MDonnell 212, King and Peare 21). 1 In ontrast to traditional regulation private politis does not operate through publi institutions suh as legislatures, ourts, or exeutive agenies. Rather, it is haraterized by the interation of private entities suh as firms, ativists and NGOs. Despite its private nature it plays a growing role in the regulation of global ommere. For example 14 perent of the world s temperate forests and seven perent of global fisheries are governed by private ertifiation systems (Vandenbergh 213). Issues that have given rise to various forms and levels of private regulation inlude environmental protetion, human rights, disrimination, working onditions, data privay, safety of employees and ustomers, endangered speies, and animal welfare. While sometimes private regulation is eventually odified in governmental regulation, there are inreasingly many examples where industries adopt expliit standards of private regulatory systems without any referene to governmental ators. Examples are the Equator Priniples or the Sustainable Forestry Initiative. Private regulation is partiularly widely used in ases where publi institutions are missing, or governane proeesses are underdeveloped or orrupt. For some issues that transend a single government suh as, regulation of labor praties within the supply hain of multinational ompanies or limate hange the required ooperation and oordination among governments has been undermined by free-rider problems, the lak of an adequate framework for international law governing multinational orporations, and the inability of existing multilateral organizations to impose santions. One suh example is the attempt to redue the availability of onflit diamonds, whih are used to fund ivil wars in West Afria. But private regulation is inreasingly ommon in the ountries with well-developed publi regulatory apaities. In the U.S., for example, more money is spent on private environmental inspetions than Federal enforement efforts (Vandenbergh 213). Ativists and observers have argued that this shift towards private solutions may reflet the inreasing diffi ulty to adopt new regulations. Vandenbergh (213) points out that in the U.S. no major environmental statutes has been enated sine the Clean Air At Amendments in 199. Mihael Brune, long-time exeutive diretor of the Rainforest Ation Network (RAN) and urrently exeutive diretor of the Sierra Club, ommented that Companies were more responsive to publi opinion than ertain legislatures were. We felt we ould reate more demoray in the marketplae than in the government. (Baron and Yurday 24). 1 Maxwell, Lyon, and Hakett (21) all this "self regulation". Vogel (21) presents the losely related idea of "ivil regulation". Vandenberg (213) uses the term "private governane". 1

4 Rather than engaging through traditional publi hannels ativists have started to target ompanies diretly via orporate ampaigns. Suh ampaigns usually onsist of a speifi demand, e.g. inrease wage rates, aompanied by an impliit or expliit threat to impose harm on the ompany if management does not omply with the demand (Baron and Diermeier 27). 2 Suh harm an take the form of onsumer boyotts, harassment of exeutives and workers, shareholder resolution, divestment ampaigns, and so forth. Though ampaigns sometimes involve disruption of operations or boyotts, the most ommon way that ativists seek to harm or reward firms is through the effet of the ampaign on the reputation of the target firm. To be suessful orporate ampaigns need to attrat media attention, either through overage in the news media or by leveraging soial media suh as Faebook and Twitter. Issues have inluded, among others, environmental protetion, human rights, disrimination, privay, safety of employees and ustomers, endangered speies, and animal welfare testing. The ativists expliit or impliit goal is private regulation, i.e. the voluntary adoption of rules that onstrain ertain ompany ondut without the involvement of publi agents. 3 Private regulation an our at the level of individual firms at the level of industries or industry segements. After global media outrage over working onditions at its main supplier Foxonn, Apple agreed to signifiantly improve labor onditions at Chinese fatories. This deision followed months of ontroversy over allegedly illegal overtime, inadequate safety onditions and poor workers housing, as well as a string of reported suiides. Perhaps even more ommon is the tait abandonment of ontroversial business praties by individual firms. The MDonald s Corp., for example, has modified its business praties in response to ativist ampaigns and in antiipation of both publi and private politis. MDonald s has hanged its ondut in the areas suh as safety, environmental stewardship, labor onditions at suppliers, animal welfare, the use of antibiotis in food animals, as well as obesity and healthy living (Baron, 26). Given the sale of global supply-hains even approahes onentrated on a single firm an have a signifiant impat. Walmart, for example, has over 1, Chinese suppliers and would be China s eighth largest trading partner if it were a ountry (Vandenbergh 213). Walmart uses supply-hain ontrating on a large sale from labor onditions to energy and emission requirements, pakaging, sustainable fisheries, or onflit-free diamonds, to name just a few. Industry surveys show that roughly half to ompanies surveyed impose environmental requirements on their suppliers that exeed regulatory requirements (Vandenbergh 27, 213). A reent example of industry-wide private regulation was triggered by the ollapse of the Rana Plaza fatory building in Dhaka, Bangladesh on April 24, 213. In the aident more than 1 garment workers, mostly women, died. The Rana Plaza fatory was a supplier to many international 2 Most orporate ampaigns tend to rely exlusively on threatened harm rather than promised rewards (e.g. endorsements). See Baron and Diermeier (27) for details. 3 In some ases ompanies and industries adopt self-regulation to forestall publi regulattion (Lyon and Maxwell 22). Our fous will be on self-regulation to prevent harm from the ations of private agents (ativists, NGOs) not publi agents (regulators, legislators, ourts). For a reent model that studies the interation between private politis and publi regulators see Egorov and Harstad (212). 2

5 retailers and brands inluding Walmart, Disney, The Gap, and H&M. Global media overage quikly pointed to lax building onstrution and safety standards and poor working onditions. After onsiderable media outrage and ativist pressure ompanies either withdrew from Bangladesh or agreed to improved safety standards. Private regulation is based on agreements between private parties. In some ases suh agreements onstitute legally binding ontrats. For example, in the wake of the Rana Plaza ollapse more than 7 ompanies, mostly leading European retail brands, established the Aord on Fire and Building Safety in Bangladesh, a legally binding agreement to improve working onditions and safety standards among overseas supplier. In other ases, the agreements are not legally binding. U.S. retailers and brands, for example, largely did not join the Aord, but joined in a separate agreement, the Alliane of Bangladesh Worker Safety, a voluntary agreement without legal fore. To be effetive agreements that are not legally binding must be self-enforing, e.g. by the redible ativist threat to restart a ampaign against a ompany that fails to omply. Whether agreements are designed to be legally binding or not depends on various fators inluding different liability exposures and legal traditions (e.g. Kaeb 28). But whether enshrined in formal ontrats or voluntary agreements private governane mehanism in pratie "play the standard-setting, implementation, monitoring, enforement, and adjudiation roles traditionally played by publi regulatory regimes" (Vandenbergh 213; p. 15). Private regulation an have substantial onsequenes. The 211 protests over the prie of ottage heese in Israel led to a 2% immediate prie redution that was sustained over a 2 year period (Hendel, Lah, and Spiegel 213). Similarly, an analysis of Indonesian suppliers in the textile, footwear, apparel setors showed an 3 perent wage inrease for suppliers to major brands suh as Nike, Addidas, and Reebok ompared to domesti manufaturers in the same setor (Harrison and Sorse 21). 4 Major brands, espeially Nike, had been aused sine the 199s for sweat-shop working onditions at their off-shore suppliers. After a sustained ampaign Nike and other retailers ommitted to odes of ondut for their suppliers and established monitoring programs. Harrison and Sorse (21) also show that the raise in wages did not lead to inreased unemployment, but was effetively redistributive in nature, analogous to fored profit-sharing. More generally, as the sope of private regulation is growing, sholars have raised onerns whether it is an adequate response to the market and governane failures that an arise in a global eonomy (e.g. Haufler 21, Bhagwati and Narlikar 213). For example, in the ontext of labor onditions some ritis argue that private regulation will undermine the ompetitiveness of low-ost suppliers and reverse labor fore partiipation for women in traditional soieties (e.g. Bhagwati and Narlikar 213). Others have argued that private regulation may underut the pressure for publi regulation, espeially in the ontext of global environmental onerns suh as limate hange. Suh laims are diffi ult to assess in the absene of a model. For example, any welfare analysis of private 4 Indonesian manufaturers in the textile, footwear, apparel setors also have higher wage ratess, about 1-2%, ompared to other manufaturing setors (Harrison and Sorse 21). 3

6 regulation must be lear about its omparison ase. First-best omparisons are often unrealisti sine the alternative to private politis is often the omplete absene of regulation due to lak of governane apaity or jurisdition, or a dysfuntional or orrupt politial proess that is inapable of implementing first-best regulatory solutions. Our paper explores this question by presenting a theory of orporate ampaigns, with a fous on their welfare impliations. To the extent that reputation is a valuable asset, the orporate ampaign is a potentially powerful inentive mehanism for induing firms to take soially benefiial ations. If publi regulation is weak or non-existent, ampaigns may well serve the soial interest. On the other hand, the objetives of ativists are not neessarily the objetives of soiety as a whole; for example, ativists may be muh more passionate about attaining their objetive than a welfaremaximizing planner would be. If so, the ampaign ould be a highly imperfet vehile for hanging the inentives of target firms. Not only would ampaigns indue firms to overdiret resoures toward addressing problems that ativists are passionately about, but the harm that ampaigns an do to firms reputation may have its own ost (e.g., making it more diffi ult for the firm whose reputation is impaired to reruit talent, have aess to apital, or grow its business with signifiant onsequenes for its suppliers and business partners). For these reasons, it is an open question to what extent orporate ampaigns would be expeted to inrease soial welfare. Indeed, it seems oneivable that they ould even derease welfare, in whih ase soiety would be better off without them, even in a ontext in whih there is no viable form of publi regulation. Our theory relies on a three-period game involving a profit-maximizing firm and ativist whose objetive is to ahieve abatement of an unregulated and untaxed soial harm that the firm, in the normal ourse of its operations would not diretly internalize. Eah period the firm an inur osts to voluntarily abate the soial harm (i.e., engage in private regulation) as a way to stohastially improve its reputation, taken here to be the firm s standing among key onstituenies inluding ustomers, urrent and prospetive employees, opinion leaders, and publi authorities. At the same time, the ativist an initiate a ampaign aimed at undermining the firm s reputation as a way of motivating the firm to inrease its abatement effort. 5 The firm s single-period profits are assumed to inrease in reputation, but at a diminishing rate, what we all diminishing stati returns to reputation. Beause reputation enhanement is valuable, the firm would engage in some degree of private regulation even without ativist pressure, though its amount would typially be less than the soially effi ient level beause it does not internalize the soial benefit of abatement. However, faed with a ampaign by an ativist, the firm not only faes headwinds in its efforts to improve its reputation, it also faes the risk that its reputation ould deline. We show that diminishing stati returns to reputation asades bak to make the firm s (endogenous) value funtion at the beginning of the seond period (whih reflets the disounted present value of expeted seond and third period profit) inrease in reputation but at a diminishing rate, what we 5 Beause the game terminates in the third period, the interesting ation takes plae in the first and seond periods. However, the third period matters beause the prospet of improving profitabillity in the third period motivates the firm to engage in private regulation in period two. 4

7 all diminishing dynami returns to reputation. With diminishing dynami returns to reputation, we show that in the initial period the only point in time at whih a ampaign will take plae in equilibrium the firm will hoose a higher level of private regulation than it would have had there been no pressure from the ativist. Private regulation in our model thus stems from two oneptually distint soures: a baseline level aimed at burnishing reputation, and an additional level (arising when the ativist launhes a ampaign) that serves as insurane against reputation loss by a firm that is (endogenously) risk averse in reputation. In this sense, private regulation in our model reflets two of the drivers identified by Haufler (21): reputation enhanement and risk management. 6 The first-period ampaign itself arises beause seond-period private regulation dereases in reputation an impliation of diminishing stati returns to reputation and if the firm s reputation is tarnished, it will engage in more abatement ativity, whih is the ativist s objetive. If there were onstant or inreasing stati returns to reputation, the interests of the ativist and the firm would be aligned, and there would be no ampaign. 7 There are two hannels in the model by whih an ativist ampaign ould inrease the expeted present value of soial welfare relative to the benhmark in whih there is no private regulation (the plausible benhmark in a global setting). First, if private regulation in the initial period is less than the level that maximizes the stati net soial benefit from abating the soial harm, the inrease in first-period private regulation engendered by the ampaign will work to inrease soial welfare. Seond, as noted, the ampaign in the first period makes it possible that the firm s reputation will deline between periods one and two, and it may also make it less likely that the firm s reputation will inrease between periods one and two. (This latter effet depends on whether the inreased private regulation in period one does not offset the headwinds reated by the ampaign.) By stohastially lowering the firm s seond-period reputation, the first-period ampaign would stohastially inrease the amount of abatement ativist in period two. The greater abatement of the soial harm works to inrease soial welfare, but this improvement is offset by the redution in the disounted present value of the firm s profit and possibly, too, by the redution in welfare of other onstituenies, suh as onsumers or employees, who derive more value when the firm s reputation is higher rather than lower. The balane of these fores is summarized by a term we all the soial return to reputation, the extent to whih seond-period soial welfare goes up or down when the firm s reputation inreases. When the soial return to reputation is negative, the seond hannel operates to inrease soial welfare. We show that the soial return to reputation is more likely to be negative when the marginal soial benefit of abatement ativity is high, when the marginal ost of abatement low, when diminishing stati returns to reputation are pronouned, and (somewhat surprisingly) the profit inrement to reputation is large (for then the diminishing stati returns to reputation have greater fore). Through as ombination of analytial results and numerial examples, we identify irumstanes under whih these hannels operate. Overall, the 6 The third driver identified by Haufler (21) is the more rapid spread of best praties for how to voluntarily regulate. 7 In fat, with inreasing stati returns to reputation, the ativist would want to assist the firm in building its reputation beause that would indue the firm to undertake more abatement ativity. 5

8 presene of the ativist may inrease or derease the expeted present value of soial welfare relative to the no-ativist benhmark. The typial ase in whih the ativist plays a onstrutive role is one in whih the marginal benefit of abatement ativity is high, the diminishing stati returns to reputation are pronouned, and the ativist is moderate, i.e. not exessively passionate about the ause of abating the soial harm. Though the primary fous of this paper is on the welfare effets of orporate ampaigns and private regulation, the analytial impliation of our model onform with some of the stylized fats about ativists. For example, in our model, the ativist s reation funtion its optimal ampaign intensity for any given level of abatement ativity by the firm is dereasing in that abatement ativity, whih is onsistent with the findings in Lenox and Eesley (29) that environmental ativists tend to target firms with higher levels of greenhouse gas emissions. Also, ativists tend to target ompanies for whom reputation is more valuable, e.g. well-known brands (King and MDonnell 212). Private regulation in both the first and seond periods derease in the firm s reputation, whih is in aord with the findings in Kothen and Moon (212) that ompanies known for being soially irresponsible tend to engage subsequently in greater levels of orporate soial responsibility than ompanies that are less irresponsible. As noted above, it is this relationship between reputation and private regulation whih motivates the ativist to mobilize a ampaign in our model. The organization of the remainder of the paper is as follows. Setion 2 desribes the model of ompetition between the firm and the ativist. Setion 3 analyzes the equilibrium of the threeperiod game. Setion 4 explores the question of whether the ativist s ampaign benefits soiety. Setion?? presents a number of robustness heks and potential extensions of the model. Setion 5 summarizes and onludes. Proofs of all propositions and lemmas are in the Appendix. 8 2 The model We onsider a model with two ators a firm and an ativist group and two key features. First, the firm s operations ontribute to a visible, but unregulated and untaxed, soial harm. Seond, the extent to whih the firm abates the harm denoted by x and the intensity of the ativist s ampaign against the firm denoted by y affet the evolution of the firm s reputation for orporate itizenship over time. Reputation for itizenship is not a posterior belief about hidden information as in a game theoreti interation between an informed and uninformed players. Instead, it is a subjetive pereption held by marketplae ators that may or may not aurately reflet an underlying reality. Reputation for itizenship should be thought of as a dimension of the firm s brand equity. One benefit of a strong reputation for itizenship ould be a higher demand for the firm s produts. A strong reputation for itizenship ould also give the firm an edge in reruiting top exeutive talent. A strong reputation may also enable the firm to eonomize on other brand 8 The proof of Proposition 1 is in the on-line appendix for this paper. 6

9 investment ativity suh as advertising or produt promotion, and it may make it easier to find partners for business deals that rely on some degree of trust. Finally, a strong reputation for itizenship might insulate the firm from private legal ativity or publi regulatory ativity. Throughout the paper, we use the terms abatement ativity and private regulation interhangeably. However, the tangible form of private regulation in pratie may be more than just an abatement level. It ould involve, among other things, adoption of a ode of ondut or a statement of priniples foused on the importane of reduing the harm; hanges in produt pakaging or harateristis that are the soure of the harm, and hanges in management praties aimed auditing and aounting how muh harm the firm has atually abated. In short, the firm s abatement effort may be both omprehensive and fairly visible. 2.1 Reputational dynamis Beause reputation is fundamentally a dynami phenomenon, our model is dynami. Speifially, the interation between the ativist and the firm is modeled as a dynami stohasti game that plays out over a finite horizon t = 1,..., T, and for simpliity we assume T = 3, whih (as will be seen below) is the smallest number of periods needed to generate interesting behavior by the ativist. The strength of the firm s reputation is r, where r I {,...,, 1,..., } is integer valued and is the key state variable in the model. We summarize the impat of reputation on the firm s profitability by a redued-form profit funtion π(r), where π( ) is stritly inreasing in r and stritly onave. In what follows, we let π r = π(r), and π r π r+1 π r. Thus π r 1 < π r < π r+1, π r 1 > π r > π r+1. We refer to this latter ondition as diminishing stati returns to reputation (DSRR), stati beause it pertains to the properties of the single-period profit funtion. When DSRR prevails the single-period profit hit from reputational loss is more signifiant than the single-period profit bump from reputational improvement. Put another way, to assume DSRR is to assume that the firm is risk averse with respet to its reputation. This strikes us as a plausible assumption. That said, we illustrate below the impliations of onstant and inreasing stati returns to reputation. The profit inrement to reputation π r plays an important role in the analysis. In what follows, it will be useful to parameterize the profit inrement as follows: π r = θ π r 1, (1) where θ (, 1) is a parameter indiating the extent of DSRR, or equivalently, the level of reputational risk aversion on the part of the firm: The lower is θ, the more signifiant is DSRR, and as 7

10 θ 1, DSRR disappears in the limit. Reputational dynamis are determined by the following proess r t = r t 1 + f t a t, where f t {, 1} is a positive shok to the firm s reputation, and a t {, 1} is a negative shok to the firm s reputation, where Pr(f t = 1) = p(x t ) Pr(a t = 1) = q(y t ), and p() =, p (x) >, q() =, and q (x) >. Thus, more private regulation in a given period inreases the probability of a positive shok in that period, and greater ampaign intensity in that period inreases the probability of a negative shok. 9 If a positive and negative shok our in the same period f t = a t = 1 they offset eah other, and the firm s reputation remains unhanged. Beause there is a one-to-one relationship between x and p and y and q, respetively, it will be analytially onvenient to model the firm and ativist as hoosing p and q diretly. Strething the terminology slightly, hereafter we refer to p and q as private regulation and ampaign intensity, respetively. Letting h u (p, q), h s (p, q), and h d (p, q) denote the probabilities that the firm s reputation inreases, stays the same, and dereases from one period to the next, we have: h u (p, q) = p(1 q) h d (p, q) = (1 p)q, and h s (p, q) = 1 h u (p, q) h d (p, q). 2.2 The firm and soiety As noted above, the soial harm the firm s business operations reates is unregulated. Possible examples inlude an environmental externality that is not regulated in the parts of the world where the firm operates, the extration of a ommons resoure by the firm or an upstream supplier in a region where property rights are weak, or unsafe working onditions in an upstream supplier s plant loated in a ountry with little or no oupational safety and health regulation. The private regulation that abates the harm omes at a private ost (p) to the firm. 1 For simpliity, we assume it is quadrati: (p) = 2 p2 to the firm. Private regulation is also soially benefiially. The 9 An alternative formulation would allow for the possibility that urrent reputational shoks ould depend on the entire history of private regulation and ampaign intensity, i.e., Pr(f t = 1) = p(x t, x t 1,..., x 1) and Pr(a t = 1) = q(y t, y t 1,,..., y 1). This formulation, whih inludes our setup as a speial ase, adds notational omplexity but relatively little additional insight. For this reason, we fous on the ase in whih hanges in reputation from the urrent to the next period depend only on urrent period private regulation and ampaign intensity. 1 Realling that x is the underlying level of private regulation and p(x) is the probability of a positive shok, (p) = C(X(p)), where X(p) is the inverse of p(x). 8

11 soial benefit w(p) of the firm s abatement ativity is assumed to be entirely external to the firm. The benefit funtion w(p) = ωp, where ω >. For later use, let p S = min { ω, 1} 1 denote the stati optimum, the level of private regulation that maximizes the stati net benefit w(p) (p). The firm is assumed to maximize disounted expeted profits using a disount fator β F (, 1). Beause the benefits of private regulation are assumed to be external to the firm, a profit-maximizing firm would have no reason to undertake it unless there was an additional soure of private benefit to the firm from doing so. In our model, that benefit omes from the prospet of reputation enhanement and the protetion against reputation loss. Of ourse, reputation management is not the only mehanism that an lead a firm to engage in voluntary private regulation. An alternative benefit of private regulation studied by Maxwell, Lyon, and Hakett (2) is that it an serve as ommitment devie to make the firm a tougher player in the politial lobbying game with proponents of publi regulation. Though this is a plausible mehanism in settings with existing (or imminent) publi regulation and well-developed institutions of governane, it would not be appliable to settings in whih publi regulation of the harm aused by the firm does not exist and is unlikely to be adopted in the future. A global ompany may well find itself in suh settings. It might operate in jurisditions where environmental protetion is weak beause no single ountry has taken responsibility for a regional or global pollutant (e.g., arbon emissions). It might rely on a supply hain, some of whose members are loated in jurisditions that effetively have no publi regulation of worker safety and health due to poor governane, orruption, or the existene of more pressing development priorities (e.g., the issues brought to light by the 213 ollapse of the Savar garment fatory in Bangladesh highlight this possibility). Or the firm may be seen as ontributing to a soial problem for whih there is no publi regulation beause the solution to the problem does not have an obvious publi regulatory remedy, or beause resolution of the problem requires multilateral agreements in an environment where suh agreement are extremely diffi ult to ahieve (e.g., onflit diamonds ). In all of these settings, a plausible reason why a firm that is not legally obligated to abate the harm that its ations (or those of its suppliers) ause would nevertheless do so is that it benefits its image among marketplae ators. 2.3 The ativist The ativist s ampaign is intended to draw publi attention to the fat that the firm s business operations reate the soial harm. It ould take the form of boyotts, divestment efforts, or disruption of operations. By hoosing a higher level of ampaign intensity whih might involve a higher expenditure of resoures aimed at organizing volunteers, or spending more resoures drawing attention to the ampaign so that it is more likely to be overed in the media the ativist inreases the likelihood that the firm s reputation will suffer a negative shok. The total ost to the ativist of a ampaign is given by γ(q) = γq2 2, where γ. We assume that the ativist s ampaign tatis boyotts or disruptions of operation have no diret ost to the firm. These tatis are used only to draw attention to the harm the firm reates in 9

12 the traditional or soial media in the hope of hurting the firm s reputation. We further assume that the ativist atually does not derive a diret benefit from hurting the firm s reputation. That is, it is no happier when the firm has a lower reputation than it is when the firm has a higher reputation. Instead, we assume that the ativist is pragmati. Instead, the ativist s only soure of benefit is the level of abatement ativity the firm provides eah period, i.e., its private regulation. We assume the ativist maximizes the differene between ψw(p) and the ost mounting a ampaign, where ψ 1 is the ativist s passion for the abatement ause. The ativist s disount fator is given by β A >. A ampaign benefits a pragmati ativist only if, by ausing the firm s reputation to derease, the firm subsequently deides to inrease the level of private regulation. In a sense, then, the ativist is akin to a prinipal in a prinipal-agent model, but it is a prinipal whose objetive funtion is not neessarily aligned with soial welfare. 2.4 Equilibrium onditions An equilibrium of our dynami stohasti game is desribed by {(p rt, q rt, u rt, v rt ) (r, t) I {1, 2, 3}}, where u rt and v rt are the firm s and ativist s values in state r, period t. These values are desribed by Bellman equations as follows: u rt = v rt = max U rt(p rt, q rt ) π r p2 rt p rt,1] 2 + β F u r,t+1 + β F { u r,t+1 h u (p rt, q rt ) u r 1,t+1 h d (p rt, q rt )} ; max V rt(p rt, q rt ) = ψw(p rt ) γq2 rt q rt,1] 2 +β Av r,t+1 +β A { v r,t+1 h u (p rt, q rt ) v r 1,t+1 h d (p rt, q rt )}, where u rt u r+1,t u rt and v rt v r+1,t v rt, and it is understood that u r4 = v r4 =. 11 U rt (p rt, q rt ) and V rt (p rt, q rt ) are stritly onave in p rt and q rt, respetively, so the Kuhn-Tuker first-order onditions are neessary and suffi ient for a unique global optimum. Using the expression for the derivatives of h u (p, q) and h d (p, q) those onditions in state (r, t) an be expressed as: p rt + β F (1 q) u r,t+1 + q u r 1,t+1 ] + ς p rt ςp1 rt = ; γq rt + β A {p ( v r,t+1 ) + (1 p)( v r 1,t+1 )}] + ς q rt ςq1 rt = ; p rt, 1] ς p rt p rt = ς p1 rt (1 p rt) = ς p rt ; ςp1 rt q rt, 1] ς q rt q rt = ς q1 ς q rt (2) (3) ; (4) rt (1 q rt) = ; ςq1 rt where ς p1 rt, ςp1 rt, ςq rt, and ςq1 rt are Lagrange multipliers. Hereafter, we let denote equilibrium values. Throughout our analysis we maintain we maintain the following assumption:. (5) 11 Note that in writing (2) and (3), we have used h s(x, y) = 1 h u(x, y) h d (x, y). 1

13 Assumption 1 For all r I, > β F (1 + β F ) π r. This assumption says that the marginal ost of private regulation at p = 1, exeeds the disounted gain from improving reputation. The impat of the assumption is to eliminate equilibria (with our without the ativist) whih involve orner solutions for private regulation (p = 1). Considering orner solutions would not hange the results, but it makes notation and verbiage more umbersome. 3 Equilibrium analysis We proeed in two steps. We first haraterize the no-ativist equilibrium what the firm would optimally do in the absene of an ativist. Essentially this involves setting q =, and analyzing the firm s dynami programming problem. We then analyze the equilibrium with the ativist. 3.1 No ativist benhmark We denote the no-ativist benhmark by the supersript. We haraterize the no-ativist benhmark through a series of propositions. Proposition 1 In the absene of an ativist, the firm s optimal level of private regulation is given by: 12 p r3 =, (6) p r2 = β F π r (, 1), (7) p r1 = β F u r2 In period 2, the level of private regulation is dereasing in reputation, i.e., (, 1). (8) p r+1,2 < p r2, (9) The value to the firm in the absene of an ativist is given by: u r3 = π r (1) u r2 = (1 + β F )π r + β2 F ( π r) 2 (11) 2 u r1 = π r + β F u r2 ( ) p 2 2 r1 + βf p r1 u r2. (12) These values are stritly inreasing in reputation in eah period, i.e., u rt >, r I, t = 1, 2, 3. (13) 12 Unless expliitly noted, the results in this and subsequently propositions that are expressed in terms of an arbitrary state r should be thought of as applying to all possible states in I. 11

14 The seond period value inrement is greater the more patient the firm, i.e., u r2 β F >, r I There is no private regulation in the terminal period, but positive amounts in the penultimate and initial periods. From (9), we see that in the absene of an ativist, firm s with stronger reputations undertake less private regulation in period 2. This is beause single-period profit is subjet to diminishing marginal returns. We now show that the firm s seond-period value is also subjet to diminishing marginal returns, whih in turn implies that the firm s private regulation in the first-period is also weakly dereasing in its reputation. In both the first and seond periods, then, a stronger reputation dampens inentives to undertake private regulation. Proposition 2 The firm s seond-period value funtion exhibits diminishing marginal returns to reputation, i.e., u r2 < u r 1,2. As a onsequene, the firm s first-period private regulation is stritly dereasing in its reputation level, i.e., p r+1,1 < p r1. Proposition 2 is an important result for our subsequent analysis. It shows that the assumed property of DSRR whih diretly shapes the relationship between private regulation and reputation in the penultimate period, 2 endogenously asades bakward through time to make the firm s value funtion onave in reputation in period 1. That is, the firm s period-one value funtion, whih presumes optimal behavior in all subsequent periods, inherits the onavity of the stati profit funtion. Reputational risk aversion thus holds dynamially. For this reason, we refer to the result that u r 1,2 > u r2 as diminishing dynami returns to reputation (DDRR). With this property, a strong reputation is a deterrent to private regulation, as indiated by the result in Proposition 2 that p r+1,1 < p r1. As we will see, DDRR plays an important role in our subsequent analysis with an ativist. Most signifiantly, DDRR implies that the firm is risk averse with respet to the loss of reputation in period 1. Given the importane of DDRR, it useful to see how varies with key parameters. From (11) and using (1) we have: { u r2 = θ π r 1 (1 + β F ) θ ( 1 θ 2) β 2 F π } r 1 2 so Thus u r 1,2 = π r 1 {(1 + β F ) ( 1 θ 2 ) β 2 F π } r 1 { u r 1,2 u r2 = π r 1 (1 θ)(1 + β F ) β2 F π ( r 1 1 θ 2 ) } 2 2 u r 1,2 ] { u r2 = π r 1 1 β θ F 1 2θ(1 ]} θ2 )β F π r 1 <, 2 12

15 where the inequality follows beause Assumption 1 implies β F π r 1 < 1 and sine θ < 1, 2θ(1 θ) 1 2. Thus, the more pronouned is DSRR (lower θ), the more pronouned is DDRR. It is also straightforward to show that lim u r 1,2 u ] r2 =, θ 1 so that DSRR is a neessary ondition for DDRR. Differentiating with respet to the disount fator β F we have u r 1,2 ] u r2 = (1 θ) π r 1 β F Given Assumption 1, a suffi ient ondition for this to be positive is {1 β F π r 1 (1 + θ) ( 1 θ 2) }. (1 + θ) ( 1 θ 2) < 1 + β F (14) whih holds if the firm is suffi iently patient or suffi iently risk averse. 13 Thus, for suffi iently high disount fators and/or high degrees of risk aversion, DDRR beomes more pronouned the more patient the firm is. We have seen that private regulation with reputation in period 1 and 2. Private regulation also delines over time for a given level of reputation. Proposition 3 Private regulation weakly delines over time, i.e., p r3 p r2 p r1. It stritly dereases between periods 1 and 2 if private regulation is positive in period 1. Proposition 3 arises beause a two-period reputational advantage is more valuable than a singleperiod reputational advantage, as refleted in the result (obtained in the proof to Proposition 3) that u r2 > π r. An impliation of Propositions 1 and 3 is that a firm that sueeds in improving its reputation in the first period will subsequently oast on its reputation by reduing the amount of private regulation it engages in the seond period. Proposition 4 Suppose a firm manages to inrease its reputation in period 1. Then the amount of private regulation it engages in period 2 will be stritly less than the amount of private regulation it engaged in period 1, i.e., p r+1,2 < p r1. Coasting provides a motivation for a pragmati ativist to ounter the firm s efforts to improve its reputation in period The equilibrium with an ativist We now turn to the haraterization of the equilibrium with an ativist. 13 In fat, beause max θ (,1) (1 + θ) ( 1 θ 2) = 32/27,β F > 5/27.19 is suffi ient for (14) to hold for all θ, 1]. 13

16 3.2.1 Preliminary results We begin by establishing several results that immediately follow from the finite-horizon struture of the game: Lemma 1 p r3 = q r3 = q r2 =, i.e., in the terminal period the firm does not engage in private regulation (as in the no-ativist ase), and in neither the terminal period and the penultimate period, the ativist does not mount a ampaign. Beause the ativist benefits only from a hange in the firm s behavior in the subsequent period, and beause the firm s behavior (trivially) does not vary in period 3, the ativist gains no benefit from a ampaign in period 2. By ontrast, the firm may want to engage in private regulation in period 2 beause the potential improvement in reputation would result in higher profits in period 3. Lemma 2 The firm s private regulation in period 2 equals the level in the no-ativist ase, i.e., p r2 = p r2. Lemmas 1 and 2 immediately lead to the following haraterization of the equilibrium values for the firm and the ativist: Lemma 3 The equilibrium values for the firm and the ativist in periods 2 and 3 are as follows: u r3 = u r3 = π r. u r2 = u r2 = (1 + β F )π r + β2 F π2 r. 2 v r3 =, v r2 = ψw(p r2). As established in Proposition 1, the firm s value is stritly inreasing in reputation level in periods 2 and 3. The ativist s value, by ontrast, is dereasing in the firm s reputation in period 2, i.e., vr2 <. The next proposition summarizes a key impliation of this result: Proposition 5 The interests of the firm and the ativist in period 1 are opposed. Beause the firm prefers to be in a higher reputation state in period 2 to a lower one, it benefits from ations in period 1 that make an inrease in its reputation more likely. Beause the ativist prefers the firm to be a lower reputation state in period 2 to a higher one, it benefits from ations in period 1 that make an inrease in its reputation more likely. 14

17 The ativist benefits by weakening the firm s reputation in period 2 beause it motivates the firm to undertake a greater level of private regulation in that period. A weaker reputation keeps the firm hungry to improve its image. This preferene by the ativist sets the stage for a orporate ampaign in period First-period equilibrium We now turn to the first period. Let w r2 w(p r2) w(p r+1,2) = ωβ F w r 1,2 w(p r 1,2) w(p r2) = ωβ F π r π r+1 ] = ωβ F π r 1 θ(1 θ) >. (15) π r 1 π r ] = ωβ F π r 1 (1 θ) >. (16) As noted in the proof of Lemma 3, vi2 = ψ w i2 < for i = r 1, r. Thus, v i2 and u i2 are positive for i = r 1, r, and the Kuhn-Tuker onditions in (4)-(5) imply that ς p r1 = ςq r1 = and p r1 > and q r1 >. 14 Moreover, beause Assumption 1 implies β F u r2 < β F u r 1,2 < 1, p r1 < 1. Thus, the only possibility for a orner solution is for q to equal 1. From the Kuhn-Tuker onditions, we an therefore derive reation funtions for the firm and ativist given by: p R r1(q) = β F u r2 + ( u r 1,2 u ] r2) q (17) { qr1(p) R βa ψ = min w γ r 1,2 ( } wr 1,2 wr2 ) ] p, 1. (18) From (17) and (8), we see that a firm with reputation r follows a simple hoie rule: its profitmaximizing private regulation is a onvex ombination of the no-ativist levels of private regulation for reputation levels r and r 1. Thus, the greater the ampaign intensity the firm expets the ativist to undertake, the more private regulation the firm will provide. Moreover, to the extent that p r 1,1 is large relative to p r1 or equivalently (from (8)) to the extent that u r 1,2 is large relative to u r2 ampaign intensity will have a stronger impat on private regulation on the margin. In other words, the ativist provides the highest inentives for the firm to engage in private regulation when DDRR is most signifiant. As shown above, DDRR tends to be large when the firm is patient and when DSRR are pronouned. Thus, patient firms for whih the loss of reputation is far more onsequential than gains to reputation tend to be most responsive to an ativist ampaign. From (15) and (16), we see that qr1 R (p) is dereasing in p. Thus, all things being equal, an ativist launhes a more intense ampaign against a firm that engages in less abatement ativity. This is onsistent with the empirial evidene in Lenox and Eesley (29) that environmental ativists tend to target firms with higher levels of greenhouse gas emissions. 14 To see why, suppose to the ontrary that p r1 =. The omplementary slakness onditions in (4) would then imply ς p1 r1 =. The first-order ondition in (4) would then redue to β F (1 q) u r,t+1 + q u r 1,t+1] + ς p r1 =, a ontradition sine u r2 >, u r 1,2 > and ς p r1. A similar proof establishes qr1 >. 15

18 An immediate impliation of (17) and (18) is that the presene of the ativist indues the firm to undertake more private regulation in period 1: Proposition 6 In the equilibrium with the ativist, the firm hooses stritly more private regulation in the fae of an ativist ampaign than in the absene of the ativist, i.e., p r1 > p r1. The ativist makes it more diffi ult for the firm to improve its reputation between periods 1 and 2, whih in isolation ats a fore to derease inentives for private regulation. The ativist makes it more diffi ult for the firm to improve its reputation between periods 1 and 2. In isolation, exogenous hanges in fators that make it harder for the firm to improve its reputation would derease inentives for private regulation. However, the ativist also puts the firm at risk of a reputational loss, and given DDRR implied by Proposition 2, the firm gains more by avoiding this downside than it gains by inreasing its reputation. Aordingly, the inrease in private regulation an be naturally interpreted as self insurane by the firm against the possibility of reputation loss. As noted above, the key to DDRR (and thus Proposition??) is DSRR. The risk aversion of the firm with respet to its reputation that is implied by DSRR is thus the pragmati ativist s lever. It is what, ultimately, reates the opposition of interest between the firm and the ativist that is the fuel for an ativist ampaign, and it is what indues the firm to hoose a higher level of private regulation in period 1 than it would have in the absene of the ativist. This point an be made even more forefully by onsidering the impliations of onstant or inreasing returns to reputation, i.e., π r π r 1 for all r I. From (7), it follows that p r2 is onstant in r with onstant returns to reputation, and p r2 is inreasing in r with inreasing returns to reputation. From (15) and (16), we would have wi2 for i = r 1, r, from whih it would follow from (5) that qr1 R (p) =. Indeed, when returns to reputation are inreasing, the interests of the firm and the ativist are fully aligned. Not only is there no need for the ativist to launh a ampaign to harm the firm s reputation, it would be ounterprodutive. If the ativist ould somehow help the firm improve its reputation, it would do so. This disussion an be summarized by the following proposition: Proposition 7 When an ativist is pragmati, a neessary and suffi ient ondition for the ativist to launh a ampaign in period 1 is if the firm is risk averse in its reputation, i.e., DSRR holds. If the firm was not risk averse in its reputation, a ampaign would be ounterprodutive for a pragmati ativist, and the ativist would even prefer to help the firm build its reputation if stati returns to reputation were inreasing. In light of Proposition??, the presene of the ativist does two distint things: it inreases the level of private regulation in period 1 (a stati effet); it hanges the transition probabilities between reputation states aross periods 1 and 2 (a dynami effet). Speifially, the probability that the firm s reputation improves hanges 16

19 from h ur h u (p r1, ) = p r1 to h ur h u (p r1, q r1 ) = p r1 (1 q r1 ), and the probability that the firm s reputation delines hanges from to h dr h d(p r1, q r1 ) = (1 p r1 )q r1. The dynami effet ould inrease or derease the expeted amount of private regulation in period 2 relative to the no-ativist ase, depending on the interplay of three fores: (i) beause the ativist s ampaign reates a positive probability of reputation loss, it is possible that the firm will end up undertaking the higher level of private regulation assoiated with the reputation level r 1, something that would not have happened without the ativist; (ii) the ampaign also works to redue the probability that the firm inreases its reputation from r to r + 1, thus dereasing the hane that the firm will undertake the lower level of private regulation assoiated with reputation level r + 1; (iii) the inrease in private regulation in period 1 might more than offset this seond effet, making it possible that the probability that the firm inreases its reputation is atually greater with the ativist than without (a rebound effet ). Overall, the dynami effet on the expeted level private regulation in period 2 is ambiguous, as summarized in the following table, whih shows the level of private regulation in state r in period 1 and expeted private regulation in periods 2 (viewed from the perspetive of period 1, state r). For ompleteness period 3 is also inluded: Period No ativist Ativist Greater under 1 p r1 p r1 Ativist { h 2 (1 h ur)p r2 + h urp r+1,2 p r,2 + ur p r2 p ] } r+1,2, Ambiguous p r 1,2 p r,2] +h dr 3 Same Rearranging terms from the seond row of the table, the presene of the ativist unambiguously inreases expeted private regulation in period 2 if and only if h ur h ur < h dr p r 1,2 p r,2] ] (19) p r2 p r+1,2 For a orner equilibrium in whih qr1 = 1, h ur h ur = p r1, (19) holds, and the ativist s presene unambiguously inreases expeted private regulation. For an interior equilibrium, a suffi ient ondition for the ativist s presene to derease expeted private regulation is that the rebound effet does not arise, i.e., h ur h ur <. A suffi ient ondition for the rebound effet not arising is this: Proposition 8 If u r 1,2 2 u r2 <, then h ur h ur <, i.e., the presene of the ativist dereases the equilibrium probability that the firm s reputation inreases between periods 1 and 2. With no rebound effet, then the presene of an ativist results in a lower probability of reputational improvement between periods 1 and 2 to go along with a (now) positive probability of 17

20 reputational impairment. As a result, when u r 1,2 2 u r2 <, expeted period-two reputation must go down and expeted period-two private regulation must go up. The suffi ient ondition implies that DSRR is not too severe, i.e., the firm is not exessively risk averse when it omes to its reputation, and thus the presene of the ativist does not turboharge the firm s inentives for private regulation so muh that the rebound effet arises. If, by ontrast, u r 1,2 2 u r2 >, the firm is suffi iently risk averse in reputation that it would buy suh large amounts of self insurane in the form of private regulation that its probability of reputation improvement atually goes up. This highlights that private regulation as self insurane ould have upside private benefits that traditional insurane would not have. The next proposition fully haraterizes the first-period equilibrium: Proposition 9 There are two possible equilibrium onfigurations: a orner equilibrium given by p r1 = β F u r 1,2, qr1 = 1 and an interior equilibrium, p r1 (, 1), q r1 (, 1) given by: ) ] β F (1 β A ψ w r 1,2 p γ u r2 + β A ψ w r 1,2 γ u r 1,2 r1 = ] ] (2) 1 + β F β A ψ γ u r 1,2 u r2 wr 1,2 w r2 ( ) ] β A ψ qr1 γ 1 β F u r2 wr 1,2 + β F u r2 wr2 = ] ]. (21) 1 + β F β A ψ γ u r 1,2 u r2 wr 1,2 w r2 The orner equilibrium arises if and only if β A ψ γ w r 1,2 Condition (22), whih an be rewritten (1 θ) ωβ Aψ γ ( β F π r 1 1 β F u r 1,2 ( ) 1 β F u r 1,2 + wr2 β F u r 1,2 ) ] + θ β F u r 1,2 1. (22) will hold only if the ativist is suffi iently patient, passionate, or ost effi ient, or if the soial benefit ω of private regulation is suffi iently large. Figure 1 shows the first-period equilibrium for the ase in whih (22) does not hold. The firm s reation funtion is upward sloping, and the ativist s reation funtion is downward sloping.. Figure 2 illustrates what happens when a parameter that enters the ativist s reation funtion, but not the firm s, hanges. (The figure shows the ase of a hange in the ativist s passion ψ). Any fator that shifts the ativist s reation funtion upward (downward) results in an equilibrium with a higher (lower) level of private regulation and a more (less) intense ampaign by the ativist in period 1, and any fator that shifts the ativist s reation funtion downward without affeting 18 ] 1