IBM Professor of Regulation & Competitive Practices
Faculty member in the Department of Managerial Economics & Decision Sciences until 2014
A good or service often costs us more than what comes out of our pocketbook. The $9.99 that a large chain store charges for a tee-shirt may cover the cost of producing, transporting and selling that tee-shirt, but not the societal costs of poorly compensated labor, emissions of pollutants and greenhouse gases, or the hollowing out of local businesses.
Many customers care about these societal costs, and so companies have an incentive to invest in, for instance, organic cotton. Doing so can substantially improve a less-established company’s reputation. But for companies that already possess rock-solid reputations, these activities do not provide the same level of benefit. As Daniel Diermeier, a professor of managerial economics and decision sciences at the Kellogg School of Management, puts it, “The payoff for investing more, and being more socially responsible, likely diminishes over time.”
Yet, established companies do continue to invest in their image. Consider Wal-Mart, which continues to spend a considerable amount of time and expense engaging in reputation-enhancing activities, such as taking steps to provide affordable health care for employees, or pledging to decrease stores’ greenhouse emissions.
Is it the case that companies like Wal-Mart are genuinely altruistic? Perhaps. But altruism need not be the only explanation, according to a new study by Diermeier and his colleagues Jose Miguel Abito, a doctoral student in economics at Northwestern University, and David Besanko, a professor of management and strategy also at the Kellogg School. Their study suggests that seemingly counterproductive levels of socially responsible activity are in fact predicted by companies acting rationally—at least once social activism is taken into account.
Company vs. Activist
The researchers set out to simulate interactions between a company and an activist hoping to undermine that company. The activist’s campaign against the company is represented as a game that unfolds across time, with each party acting in its own best interest. The company’s goal is to gradually enhance its reputation while expending as little effort as possible. The goal of the activist, on the other hand, is to encourage effort by preventing the company’s reputation from getting too good, which would in turn allow the company to coast on that sterling reputation instead of engaging in even more socially responsible activities.
The activist has two tools at its disposal: criticism and confrontation. Criticism—which represents activities such as letter-writing campaigns or shareholder resolutions—calls attention to a company’s shortcomings and, when effective, steadily chips at the company’s reputation. However, confrontation—which describes activities geared toward creating a well-publicized spectacle, or crisis—has the potential to deliver a sudden, stinging blow to the firm’s reputation. (Consider, for a real world correlate, the rash of bad publicity Apple faced over working conditions at Chinese factories operated by its contract manufacturer Foxconn.)
As the activist goes about its business, the company must decide how little socially responsible activity it can get away with doing while still building, or at least defending, its reputation. The company cannot ward off a crisis per se—if a company sells burgers, after all, it is unlikely to ever completely appease vegetarians—but it can build enough goodwill to cushion the impact of a crisis.
Researchers varied factors such as the activist’s level of patience (that is, the amount of time and thus resources it can devote to the campaign), the effectiveness of the activist’s attacks, and the extent to which a firm values its reputation.
By providing downward pressure on the company’s reputation, an activist keeps a company motivated to do more good deeds than it would otherwise do.
They found that, over the short term, the presence of an activist actually tends to reduce the amount of reputation-building work a firm is willing to engage in. If a firm does good deeds and is still attacked, says Diermeier, then the firm may become discouraged and cut back its socially responsible activities. But over the long term, as the researchers suspected, the activist does prod the company to engage in more reputation-enhancing activity than it would in the absence of the activist. This suggests that activism serves a real social purpose: by providing downward pressure on the company’s reputation, an activist keeps a company motivated to do more good deeds than it would otherwise do. Even companies with seemingly strong reputations have an incentive to build a buffer.
Tempting Targets and Dangerous Activists
In addition to providing an explanation for why companies like Wal-Mart continue to devote resources to building their image, the study provides an intriguing answer to another longstanding question. “Large Western oil companies often complain that they’re being targeted by activists, while the activists do not go after Chinese oil or nationally owned oil companies with far worse environmental records,” Diermeier remarks. “So they always say, ‘Why are you going after us? You’re not going after the guys over there.’ And the answer our model provides is, well, that is true because Chinese local competitors do not have brand equity; that’s not the way their business is structured. Their reputation is much less valuable to them than it is to the large, well-integrated, globally operating multinational companies.” In other words, an activist can most effectively influence a company that holds its reputation in very high esteem, so why would an activist with limited resources bother with a company that does not?
The researchers’ study also tells us something about which activists tend to fare best and thus pose the most danger to firms. A patient activist—and Diermeier points to Greenpeace as a good example—is at an advantage because it has the time and the means to successfully induce a crisis. But interestingly, criticism alone is not always the most effective approach. All else being equal, activists who engage in a combination of criticism and confrontation generally do best of all. If an activist relies solely on criticism, it does not push a company’s reputation down enough. “But if you’re only creating a crisis, then at some point the company gives up,” Diermeier explains. The risk for the activist is that the company may simply stop trying to please you. For similar reasons, the most effective activist is passionate, but not too radical. Says Diermeier, “There’s kind of a sweet spot in the middle.”
Abito, Jose Miguel, David Besanko, and Daniel Diermeier. (Under review). “Corporate Reputational Dynamics, Private Regulation, and Activist Pressure.”
Diermeier, Daniel. 2012. When Do Company Boycotts Work? Harvard Business Review Blog Network.
Diermeier, Daniel. 2011. Reputation Rules: Strategies for Building Your Company’s Most Valuable Asset. New York: McGraw-Hill.