Newswise — When faced with increased competition, one might expect companies to pull back from investments in employee safety training, environmental protections, and their local communities—activities that show them to be good corporate citizens, but might not directly contribute to their financial returns.

Yet a recent analysis of companies representing 90% of world stock market capitalization found the opposite to be true: In the face of intensified competition, companies increase their use of corporate social responsibility (CSR) as a profitable strategy to build loyalty and trust.

“CSR is part of establishing very valuable relationships with workers, suppliers, and customers,” said Prof. Ross Levine. “It signals that a firm is trustworthy.”

Levine’s new working paper is the first study of how competition shapes companies’ activities related to corporate social responsibility around the world. Co-authored Wenzhi Ding and Chen Lin from the University of Hong Kong, and Wensi Xie from the Chinese University of Hong Kong, it was made possible by the increasing amount of data available on firms’ CSR activities—the result of years of demands for transparency by shareholders and activists.

“When I first started reading about corporate social responsibility, it was couched in terms of business leaders acting on good intentions, ethics, and morality. I was a bit skeptical,” said Levine, an expert on how regulations shape economies. “It’s possible they could have good intentions, but I wondered about that being the driving force behind big investments in strengthening connections with workers and customers and suppliers and communities.”

Stakeholder capitalism

Levine and his co-authors used a dataset of competition laws across countries, including rules on mergers and acquisitions, to create an index of which countries are more or less favorable to competition. They combined that with data from Thomson Reuters on CSR activities related to worker safety and benefits, treatment of customers and suppliers, and environmental protections. The sample included about 14,000 firms in 47 countries from 2002 to 2015.

Across countries, they found that higher levels of competition were associated with higher levels of CSR activities, and that intensifying competition boosts those activities. These results were clear even when controlling for various firm, industry, and country characteristics. Rather than pulling back from these investments in the face of greater competition, companies seem to be doubling down.

“Our empirical findings are inconsistent with the traditional view that competition induces firms to focus on short-term survival and therefore forgo investments that pay off in the long run,” Levine says.

The findings support a “stakeholder” theory of why firms invest in CSR. Under this interpretation, firms engage in CSR because they often have to rely on implicit agreements with stakeholders—writing down and enforcing formal contracts about every activity is impossible. CSR acts as a signal of a firm’s trustworthiness to shareholders, employees, and customers, Levine says.

“The effectiveness of those implicit agreements depends on stakeholders’ trust that the firm will honor its commitments,” Levine says. “One strategy for doing this is by investing in CSR activities, such as ensuring worker well-being and providing safe products to customers, fulfilling informal obligations to suppliers, and protecting the environment.”

Levine also found that the relationship between competition and CSR is even stronger in countries where those socially responsible activities are more highly valued. They constructed a country-specific measure of how much citizens value things like workers’ rights or the environment, which they call their social norms index. They found that the relationship between CSR and competition was twice as strong in countries that were in the top half of the index.

Ownership structure matters

Consistent with the stakeholder theory of why firms invest in CSR, the researchers also found that different ownership structures change the equation. For example, firms with corporate owners that have longer investment horizons, such as banks and insurance firms, tend to engage in more CSR activities than those owned by hedge funds, which are generally more focused on the short term.

Family-owned firms were also less likely to engage in CSR activities, possibly because they develop higher levels of trust over several decades, while other firms have shorter-horizons.

Lastly, they found that the degree to which a firm increases CSR activities in response to an intensification of competition depends on financial constraints. Many CSR activities are expensive. Thus, firms that cannot easily borrow have trouble increasing CSR when the intensity of competition picks up.

In a related paper, Levine and his co-authors found that the stock prices of firms that scored higher on CSR activity indexes before the COVID-19 pandemic hit the global economy performed significantly better during the pandemic than those that scored low—indicating that that CSR activities acted as a buffer from those wild market swings. That finding supports the theory that those types of activities greater loyalty among stakeholders, who may be more willing to stick around in tough times.

Corporate social responsibility is often viewed in opposition to Milton Friedman’s famous assertion that the only social responsibility of a business is to “engage in activities designed to increase its profits.”  Yet Levine concluded that not only is CSR compatible with the pursuit of profits, but the two now go hand-in -hand—as long as firms are operating in competitive environments.

“Perhaps, in order to promote CSR, the key role of public policy is to make sure markets are contestable,” he said.