Exit vs. Voice

The American Revolution started with a boycott of English tea, and the boycott of Montgomery buses was a key event in the civil rights movement. Not only are boycotts integral to American history, but they are also a very popular form of political engagement: 38% of Americans are currently boycotting at least one company.  Boycotts are becoming popular also in the investment world, in the form of divestment:  when Morningstar started ranking mutual funds based on their sustainable investing criteria, $24 billion flowed into “high sustainability” funds and $12 billion flowed out of “low sustainability” funds (Hartzmark and Sussman, 2019). What are the welfare consequences of these boycotts and divestments? How do they compare with other forms of political engagement at the corporate level?

In a recent paper we try to answer these questions.  For concreteness we focus on the case of an environmental externality, pollution. We assume that a fraction of the population is “socially responsible” in the sense that these individuals put a positive weight (the social responsibility parameter) on aggregate welfare when they make decisions. We study the welfare consequences if these socially responsible stakeholders exercise their exit option (divestment or boycott) or their voice one (engagement).

We show that the two forms of exit work in a similar fashion and they are not very effective. Even ignoring incentive issues, exit produces an effect less than proportional to the mass of socially responsible stakeholders:  if 10% of agents divest/boycott, less than 10% of firms become clean. The reason is that exit works by impacting prices of goods or shares. Yet, the reduction in prices stimulates the demand of the purely selfish consumers/investors, reducing the ultimate impact exit has on pollution.  The magnitude of the response depends on the slope of the demand curve, which is driven by agents’ risk tolerance for investors and by the utility of the good for consumers.

Once we factor in individual incentives, we find that that there is no simple relationship between the individual incentive to participate and the social incentive to create clean firms. Divesting or boycotting can lead to too little or too much exit from the perspective of a benevolent planner. However, when we focus on a level of the social responsibility parameter close to what is observed in experimental evidence, we find that the equilibrium level of exit is zero, unless pollution is extremely harmful.

While divesting and boycotting are fairly “institution free”, there are multiple ways to express voice, all of them highly regulated. As a starting point we abstract from any existing rule and reduce voice to a vote: shareholders are presented with the choice of whether the firm they own should be clean or dirty. The only time an individual shareholder’s vote matters is when she is pivotal. Thus, as in Hart and Zingales (2017), we assume that shareholders will vote as if their vote were pivotal. A pivotal shareholder trades off the net social benefit from the clean technology, weighted by the shareholder’s social parameter, against her own capital loss resulting from the choice of that technology. The net social benefit equals the reduced pollution minus the cost of generating that reduction.  If shareholders are well-diversified, the personal capital loss is negligible. Thus, the first effect dominates and socially responsible shareholders vote in line with a benevolent planner’s goal. Interestingly, this result is true regardless of the weight socially responsible shareholders put on aggregate welfare, as long as this weight is positive.

There is a presumption in corporate law that individual shareholders should not interfere with board decisions because they are uninformed and they might have distorted incentives. In fact, our paper shows that when it comes to social issues small diversified shareholders have the best incentives. A large shareholder or even a manager with stock options is too reluctant to reduce pollution from a social point of view because they bear too much of the cost. A well-diversified atomistic investor does not suffer from the same problem.

What about information? We show that mutual funds can solve the problem. A “Green” fund can use engagement as a marketing strategy and it will attract the money of socially responsible investors. The fund can then become informed and vote according to the investors’ preferences in each corporate resolution.

In our analysis we take social preferences as given. As a result, we miss an important benefit of exit campaigns: their effect on social preferences. When it comes to changing people’s preferences and pressuring purely selfish individuals to behave in a socially responsible way exit is superior to voice. Yet, there is no guarantee that exit’s ability to succeed is linked to the social desirability of its goal. Thus, incorporating social pressure and changing preferences is unlikely to alter the fundamental result that voice is more aligned to social incentives than exit.

One question raised by our paper is why social engagement is relatively rare in spite of all its desirable properties. In some cases, engagement is infeasible because somebody owns a majority of the votes, such as Mark Zuckerberg with Facebook, or the company is privately held, such as Koch Industries. We think that an important additional factor resides in the current U.S. proxy system, which tends to limit shareholders’ ability to influence corporate policy. The restrictions reflect a fear that individual shareholders are activists in the sense that they put a lot of weight on a single issue. If instead individuals are socially responsible (in the way we define), this fear is unfounded. Individual shareholders have the incentive to vote on issues in a socially optimal way and their engagement can lead to more efficient outcomes

The complete paper is available for download here.