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E-MailPhilip Bond is a Professor of Finance and Business Economics at the University of Washington, and Doron Levit is the Marion B. Ingersoll Endowed Professor of Finance and Business Economics at the University of Washington Foster School of Business. This post is based on their recent article forthcoming in the Journal of Financial Economics.
In our paper “ESG: A panacea for market power?,” now published in the Journal of Financial Economics, we investigate a fundamental question: What happens when firms credibly pledge to treating stakeholders better than market conditions would dictate?
Consider these common examples:
- Firms pledge generous compensation and favorable working conditions for employees.
- Companies pledge environmental stewardship to their customers.
- Businesses commit to pay “fair” prices to suppliers for inputs like coffee or cacao beans.
These types of corporate commitments have grown significantly in recent decades as market-primacy doctrine has receded. Understanding the consequences of these pledges has become increasingly important in today’s business landscape.
Historically, these pledges have appeared under various labels, most notably “corporate social responsibility.” Today, they are most closely associated with the “social” pillar of ESG policies—the terminology we adopt throughout our analysis.
Our aim is to study the basic economics of ESG-pledges to treat stakeholders better than market conditions alone dictate. We approach this analysis at multiple levels:
- What is the impact of a single (“thought leader”) firm’s ESG pledges?
- What ESG pledges would a firm choose to make? How does this choice relate to a firm’s broader orientation—whether shareholder-focused or concerned with broader stakeholder welfare?
- How do different firms’ ESG pledges interact? In particular, what pledges emerge when firms compete not only in product and labor markets but also in their ESG commitments?
To illustrate our findings, we summarize our results in the context of firms pledging favorable employee treatment. However, we emphasize that all our conclusions have direct parallels when firms make similar pledges to customers—the underlying economic mechanisms and outcomes are isomorphic between these stakeholder groups.
Concretely, we examine two firms competing à la Cournot in the labor market. In this model, each firm independently sets its hiring target, and equilibrium compensation—or more broadly, employment conditions—is determined by the intersection of these hiring targets with the labor supply curve.
All our conclusions build on the following core insight: Aggressive ESG pledges make a firm a softer competitor in the labor market, while mild ESG pledges make it a fiercer competitor.
The former anti-competitive effect of aggressive pledges stems directly from a firm pricing itself out of the labor market through overly generous commitments. When a firm pledges very high employee compensation, it later concludes at the hiring stage that workers cannot produce enough value to justify their elevated cost—consequently reducing its hiring targets.
The latter pro-competitive effect of mild pledges is perhaps more surprising and requires further explanation. Absent any ESG pledge, each firm reduces its hiring below the price-taking benchmark (where marginal product equals wages) because doing so pushes the wage rate down. This is the well-understood monopsony effect, the magnitude of which depends on a firm’s market power. A mild ESG pledge proves pro-competitive because it commits a firm to ignore this monopsony incentive to restrict hiring. Once a firm has pledged to pay slightly more than market conditions dictate, reducing hiring no longer delivers any benefit to the firm.
With this core result in hand, we turn to the questions we laid out above.
What is the impact when a single “thought leader” firm adopts ESG pledges?
Our research shows that mild pledges intensify labor market competition, elevating compensation at both the ESG firm and its non-ESG competitors. This leads to increased total industry employment as hiring expands across firms. The ESG firm gains a competitive advantage, boosting its profits and creating additional value for shareholders. Meanwhile, non-ESG competitors lose out, resulting in an overall decline in total industry profits despite the ESG firm’s gains.
In contrast, aggressive pledges backfire, because they reduce labor market competition. The ESG firm’s profits fall, while those of its competitors rise. The reduction of labor market competition means that one firm’s “generous” ESG pledge hurts employees at competing firms by reducing their wages.
What ESG-pledge would a firm choose to make?
Perhaps surprisingly, even a purely shareholder-orientated firm benefits from a mild ESG pledge. This is a direct consequence of the pro-competitive effect described above. In fact, ESG pledges give shareholder-orientated firms all the competitive advantage they could wish for, and allow them to act as Stackelberg leaders.
At least according to their own accounts, firms have increasingly broadened their objective to encompass broader measures of stakeholder welfare. A stakeholder-oriented firm naturally adopts a more generous ESG policy than a shareholder-orientated firm; specifically, it adopts an ESG policy that is right on the boundary between where a mild and pro-competitive ESG pledge tips over to an aggressive and anti-competitive pledge. These ESG-pledges, however, are excessively generous from the perspective of society overall; the problem is that the ESG firm grows too large relative to its non-ESG competitors, and this is inefficient. Thus, paradoxically, society could benefit if these stakeholder-oriented firms were to rebalance their approach, marginally prioritizing shareholder interests over broader stakeholder considerations.
How do different firms’ ESG pledges interact?
So far, we’ve considered the case in which only one “thought leader” firm makes an ESG pledge. We next consider the case of multiple ESG firms, leading to the third part of our analysis.
What happens when two shareholder-orientated firms compete in ESG polices? On the one hand, each competitor has a strong incentive to marginally outdo its competitor’s ESG pledge, because doing so delivers pro-competitive effects of the type described above. Such competition will drive ESG pledges to become more generous. But on the other hand, a firm whose competitor has made a very generous ESG pledge will profit from abandoning ESG altogether and reverting to simply paying its employees what market forces dictate. As such, our analysis predicts that ESG pledges will be unstable over time, with mild ESG pledges turning into more generous ones, which in turn revert to market-driven competition without ESG pledges.
Last but not least, what happens when two stakeholder-orientated firms compete in ESG pledges? Recall that a single stakeholder-orientated ESG firm grows too large relative to its competitors, imposing social costs. Competition between a pair of stakeholder-orientated ESG firms restores balance. Indeed, the equilibrium outcome is that both firms adopt an ESG pledge that exactly equals the market wage in a hypothetical economy without any market power. Consequently, competition in ESG pledges between stakeholder firms cures the problem of monopsony, delivering the “panacea” in our title.
Implications of our analysis
Our analysis has important implications that go beyond the specific context of our model.
- First, our analysis suggests two possible drivers for the recent rise in ESG: the rise of concentration and market power in key industries across the US economy and a shift in the strength of investors’ pro-social preferences.
- Second, our analysis suggests that ESG-linked executive pay offers no discernible social value, and stakeholder capitalism is best served when managers maintain a focus on profit-maximization, with boards strategically setting ESG policies to mitigate any adverse impacts that profit-maximization may have on other stakeholders of the firm.
- Third, while regulations that facilitate transparency and disclosure of ESG policies contribute to the efficacy and adoption of these policies under the shareholder primacy paradigm, they matter much less for the adoption of ESG policies under the stakeholder capitalism paradigm.
Overall, our analysis relates the adoption of ESG policies to the nature of competition between firms and the prevailing corporate governance paradigm. The paper is available here: https://www.sciencedirect.com/science/article/abs/pii/S0304405X24002149
