Corporate responsibility and sustainability – Tilburg University
Lecture 1 – the corporations in the Neo-classical model and its challenges
What is a corporation?
- Sole proprietorship: the owner is the firm. Means that there is unlimited personal liability.
Easy to start, but does not protect the individual entrepreneur well.
- Partnership: all partners are liable for the debts, they also have unlimited liability.
- Limited liability companies: firm is a legal entity with contractual rights and obligations.
Limited liabilities. Separation between ownership and control (think of shareholders). This
separation creates problems, as you can’t influence if the corporation acts in your best
interest. Joint stocks are owned by shareholders
In this course, we will focus on the limited liability firms.
Adam Smith: free market is the invisible hand that allocates resources efficiently.
The company and its stakeholders: customers, environment, NGO’s, government, local
communities, employees, suppliers, shareholders.
In the perfect world, there are:
- Complete contract specifies: all rights and obligations of all parties are known, but this is not
possible.
- Everyone has perfect information: no agency costs.
How to maximize social welfare in this neo-classical model?
Milton Friedman: the one and only social responsibility of business is to use its resources and
engage in activities designed to increase its profits.
In other words, by maximizing shareholder value, all other stakeholders also improve their welfare in
the Neo-Classic model.
The Friedman doctrine: their responsibility is to conduct their business with their designers,
generally making as much money as possible, while conforming to basic rules of society, laws, and
ethical custom.
The manager is spending is own resources. If these are social responsibilities, they are of individuals
and not of business.
The Neo-Classical model and externalities
- Positive externalities: employee training increases productivity and loyalty, but also benefits
other employers.
- Negative externalities: fertilizers being produced by chemical companies. Farmers use
fertilizers to boost their production, but the residuals rain away and go via the soil into the
oceans, leading to “dead zones”.
How to deal with externalities?
- Pigouvian Tax: offset negative externalities with tax, to punish companies or consumers.
Encourage positive externalities with subsidy. Therefore, the government plays a central role
in welfare economies.
- Coase Theorem: the producer purchases rights to pollute. Producer invests in new
technology or clean up pollution. Or, the community is compensated for the negative
externalities. The government taxes the polluter and compensates the victims. If there is no
, transaction costs, parties can always find efficient solutions. Government plays some role,
but not central role.
Firms who have negative externalities can directly pay the victims, try to reduce the pollution, or let
the government/market/regulator influence the situation.
Neo-classic model-challenges:
- Incomplete contracts: future generations and mother nature could not join the negotiation
today. Impossible to contract all possible future scenarios. Hard to measure and quantify all
the externalities. Accountability is quite a challenge!
- Information asymmetry: it’s hard to quantify firms’ impact on the environment and society.
Hard to monitor and verify firm’s clean up activities. We don’t have all the information to
link externalities to someone.
Accountability
Who is responsible for the melting glaciers? How much compensation should be paid by whom? Who
should be compensated? By how much?
Corporate governance system (from top to bottom)
- Shareholders: capital providers, residual owners, receive dividends, have voting rights
- Board of directors: nominated by shareholders, monitors, advices manager
- Manager: control rights, fiduciary duty
- Firm: limited liabilities, pooling resources for long-term risky projects
Could shareholder value maximization work?
Shareholders are the residual owner of the firm. They have voting rights about the firm decisions.
They can nominate the board of directions.
However, there are challenges: incomplete contract (separation of ownership and control, managers
pursue self-interests) and information asymmetry (hard to monitor and verify).
Summary:
- The invisible hand. Corporations are legal entities, with separated ownership and control,
and limited liabilities.
- Shareholder value maximization.
- Mitigating negative externalities with tax and encourage positive externalities with
subsidies.
- Efficient solutions for externalities (in the perfect world).
- Externalities, incomplete contracts and information asymmetry.
Lecture 2 – corporate governance structure
Agency theory
- Separation of ownership and control : managers (the agent) control the firm, while
shareholders (the principals) own the firm.
- Investors are the capital providers to the business, and managers control the firm.
- Will the managers and investors have a conflict of interest? Will investors get their money
back? Who has the residual control rights of the company?
Principal and agent relationship: examples
Citizens (principal) and politicians (agent) > political science
Patients (principal) and doctors (agent)
Employers (principal) and employees (agent) > managerial accounting
, Who controls the company?
Residual control means the right to decide on: cash flows, key resources, company strategy,
management hire and fire, and voting rights.
Discussion: how do the following players control a company? Shareholders, creditors, managers,
board of directors, regulators.
Key conflicts of interests in key relationships
- Shareholder vs. manager: ownership and control. Minority investor protection, voting rights,
large investors, executive compensation, change of ownership, etc.
- Shareholders vs. creditors: optimal capital structure, cost of capital, debt overhang, risk
taking, etc.
- Shareholders vs. stakeholders: corporate social responsibilities, employee rights and
regulations, social and environmental externalities of business.
- Institutional shareholders vs. individual shareholders : large shareholders may influence
firms at the expense of other shareholders.
Jensen and Meckling (1976)
- Separation of ownership and control lead to agency problems.
- Agency problem exists in all organizations and all cooperative efforts.
- Corporation is a legal fiction that serves as a nexus of contracts among individuals: no legal
obligation for firm to pursue any social responsibilities.
- Agency costs: if you start a company and you own 100%, all your effort would be translated
in the financial outcome and you bare 100% of the consequences. But when you start sharing
ownership, everybody efforts contribute to the losses and gains. All your effort will be
shared, all your risks will be shared. Your incentives are not 100% aligned anymore.
Three different types of agency costs:
- Monitoring costs by the principle: shareholders want to know what the managers are doing,
are their actions aligned with firm interest?
- Bonding costs by the agent: manager needs to convince the investors that he is doing a good
job.
- Residual losses: the rest of the costs (not covered by monitoring/bonding).
Examples of agency costs:
- Monitoring costs: board of directors to monitor managers and represent shareholder’s
interest. Large shareholders monitor managers. Shareholder activism to monitor and
influence management.
- Signaling/bonding costs: managers pay dividends, signal to shareholders that the firm is
profitable. Timely and honest disclosure of crucial information to stakeholders (e.g. annual
financial reports).
- Residual costs: managers pursue their own interest at the cost of the principals > costs when
there is no alignment.
Agency costs in the corporate world
CEO pursuing self-interests: shirking, management perks, tunneling, management entrenchment,
excessive risk taking, empire building, accounting frauds.
Shirking:
Lecture 1 – the corporations in the Neo-classical model and its challenges
What is a corporation?
- Sole proprietorship: the owner is the firm. Means that there is unlimited personal liability.
Easy to start, but does not protect the individual entrepreneur well.
- Partnership: all partners are liable for the debts, they also have unlimited liability.
- Limited liability companies: firm is a legal entity with contractual rights and obligations.
Limited liabilities. Separation between ownership and control (think of shareholders). This
separation creates problems, as you can’t influence if the corporation acts in your best
interest. Joint stocks are owned by shareholders
In this course, we will focus on the limited liability firms.
Adam Smith: free market is the invisible hand that allocates resources efficiently.
The company and its stakeholders: customers, environment, NGO’s, government, local
communities, employees, suppliers, shareholders.
In the perfect world, there are:
- Complete contract specifies: all rights and obligations of all parties are known, but this is not
possible.
- Everyone has perfect information: no agency costs.
How to maximize social welfare in this neo-classical model?
Milton Friedman: the one and only social responsibility of business is to use its resources and
engage in activities designed to increase its profits.
In other words, by maximizing shareholder value, all other stakeholders also improve their welfare in
the Neo-Classic model.
The Friedman doctrine: their responsibility is to conduct their business with their designers,
generally making as much money as possible, while conforming to basic rules of society, laws, and
ethical custom.
The manager is spending is own resources. If these are social responsibilities, they are of individuals
and not of business.
The Neo-Classical model and externalities
- Positive externalities: employee training increases productivity and loyalty, but also benefits
other employers.
- Negative externalities: fertilizers being produced by chemical companies. Farmers use
fertilizers to boost their production, but the residuals rain away and go via the soil into the
oceans, leading to “dead zones”.
How to deal with externalities?
- Pigouvian Tax: offset negative externalities with tax, to punish companies or consumers.
Encourage positive externalities with subsidy. Therefore, the government plays a central role
in welfare economies.
- Coase Theorem: the producer purchases rights to pollute. Producer invests in new
technology or clean up pollution. Or, the community is compensated for the negative
externalities. The government taxes the polluter and compensates the victims. If there is no
, transaction costs, parties can always find efficient solutions. Government plays some role,
but not central role.
Firms who have negative externalities can directly pay the victims, try to reduce the pollution, or let
the government/market/regulator influence the situation.
Neo-classic model-challenges:
- Incomplete contracts: future generations and mother nature could not join the negotiation
today. Impossible to contract all possible future scenarios. Hard to measure and quantify all
the externalities. Accountability is quite a challenge!
- Information asymmetry: it’s hard to quantify firms’ impact on the environment and society.
Hard to monitor and verify firm’s clean up activities. We don’t have all the information to
link externalities to someone.
Accountability
Who is responsible for the melting glaciers? How much compensation should be paid by whom? Who
should be compensated? By how much?
Corporate governance system (from top to bottom)
- Shareholders: capital providers, residual owners, receive dividends, have voting rights
- Board of directors: nominated by shareholders, monitors, advices manager
- Manager: control rights, fiduciary duty
- Firm: limited liabilities, pooling resources for long-term risky projects
Could shareholder value maximization work?
Shareholders are the residual owner of the firm. They have voting rights about the firm decisions.
They can nominate the board of directions.
However, there are challenges: incomplete contract (separation of ownership and control, managers
pursue self-interests) and information asymmetry (hard to monitor and verify).
Summary:
- The invisible hand. Corporations are legal entities, with separated ownership and control,
and limited liabilities.
- Shareholder value maximization.
- Mitigating negative externalities with tax and encourage positive externalities with
subsidies.
- Efficient solutions for externalities (in the perfect world).
- Externalities, incomplete contracts and information asymmetry.
Lecture 2 – corporate governance structure
Agency theory
- Separation of ownership and control : managers (the agent) control the firm, while
shareholders (the principals) own the firm.
- Investors are the capital providers to the business, and managers control the firm.
- Will the managers and investors have a conflict of interest? Will investors get their money
back? Who has the residual control rights of the company?
Principal and agent relationship: examples
Citizens (principal) and politicians (agent) > political science
Patients (principal) and doctors (agent)
Employers (principal) and employees (agent) > managerial accounting
, Who controls the company?
Residual control means the right to decide on: cash flows, key resources, company strategy,
management hire and fire, and voting rights.
Discussion: how do the following players control a company? Shareholders, creditors, managers,
board of directors, regulators.
Key conflicts of interests in key relationships
- Shareholder vs. manager: ownership and control. Minority investor protection, voting rights,
large investors, executive compensation, change of ownership, etc.
- Shareholders vs. creditors: optimal capital structure, cost of capital, debt overhang, risk
taking, etc.
- Shareholders vs. stakeholders: corporate social responsibilities, employee rights and
regulations, social and environmental externalities of business.
- Institutional shareholders vs. individual shareholders : large shareholders may influence
firms at the expense of other shareholders.
Jensen and Meckling (1976)
- Separation of ownership and control lead to agency problems.
- Agency problem exists in all organizations and all cooperative efforts.
- Corporation is a legal fiction that serves as a nexus of contracts among individuals: no legal
obligation for firm to pursue any social responsibilities.
- Agency costs: if you start a company and you own 100%, all your effort would be translated
in the financial outcome and you bare 100% of the consequences. But when you start sharing
ownership, everybody efforts contribute to the losses and gains. All your effort will be
shared, all your risks will be shared. Your incentives are not 100% aligned anymore.
Three different types of agency costs:
- Monitoring costs by the principle: shareholders want to know what the managers are doing,
are their actions aligned with firm interest?
- Bonding costs by the agent: manager needs to convince the investors that he is doing a good
job.
- Residual losses: the rest of the costs (not covered by monitoring/bonding).
Examples of agency costs:
- Monitoring costs: board of directors to monitor managers and represent shareholder’s
interest. Large shareholders monitor managers. Shareholder activism to monitor and
influence management.
- Signaling/bonding costs: managers pay dividends, signal to shareholders that the firm is
profitable. Timely and honest disclosure of crucial information to stakeholders (e.g. annual
financial reports).
- Residual costs: managers pursue their own interest at the cost of the principals > costs when
there is no alignment.
Agency costs in the corporate world
CEO pursuing self-interests: shirking, management perks, tunneling, management entrenchment,
excessive risk taking, empire building, accounting frauds.
Shirking:
