Corporate Reputational Dynamics, Private Regulation, and Activist Pressure

Abstract

We model the interaction between a profi…t-maximizing …firm and an activist using an in…nite-horizon dynamic stochastic game. The fi…rm enhances its reputation through “self-regulation”: voluntary provision of an activity that reduces a negative externality. We show that in equilibrium the externality-reducing activity is subject to decreasing marginal returns, which can cause the fi…rm to “coast on its reputation,” i.e., decrease the level externality-reducing activity as its reputation grows. The activist, which bene…fits from increases in the externality-reducing activity, can take two types of action that can harm the …firm’'s reputation: criticism, which can impair the …firm’'s reputation on the margin, and confrontation, which can trigger a crisis that may severely damage the fi…rm'’s reputation. An increase in the probability of a crisis in a given reputational state has the direct effect of decreasing the firm’'s externality-reducing activity in that state. But the activist changes the reputational dynamics of the game by tending to keep the firm in reputational states in which it is highly motivated to invest in externality-reducing activity. The paper provides both a positive and normative theory of anti-corporate activism. Using computational analysis, criticism and confrontational activity are shown to be imperfect substitutes. The more patient the activist and/or the more passionate it is about externality reduction, the more likely it is to rely on confrontation. The more patient the fi…rm and the more important corporate citizenship is to the fi…rm'’s brand equity, the more likely that it will be targeted by an activist that relies on confrontation. Both the long-run and the discounted net social benefit from externality reduction tend to increase due to the presence of the activist, but generally not to levels that exceed the …first-best level. In this sense, the activist’s impact on private regulation can make it a positive force for social welfare when public regulation is ineffective or impossible.

JEL Classification: C63, C73, L31